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Cover photo: Filip Devroe of Sanderus Antiquariaat. Map by Ortelius
01_2006_4142_cover_EN.indd 2 25-09-2007 9:01:49
EUROPEAN COMMISSION
Bureau of European Policy Advisers

CHINA, THE EU AND THE WORLD: GROWING IN HARMONY?
侚L , M%㌻㍇=: TYü侚+[Z㌰
by
Frederic Lerais
Mattias Levin
Myriam Sochacki °
Reinhilde Veugelers °°
° Responsible for the political part (myriam.sochacki@ec.europa.eu);
°° Responsible for the economic part (reinhilde.veugelers@ec.europa.eu)
July 2006
01_2006_4142_txt_EN.indd 1 12-07-2007 10:43:02
DISCLAIMER
The Bureau of European Policy Advisers (BEPA) is a department of the European
Commission, reporting. directly to the President. It provides advice to the President and the
Commissioners and formulates recommendations on issues regarding the policy of the EU.
BEPA focuses on issues of a strategic or structural nature and concentrates on the earlier stages
of the policy development cycle and the development of policy options for consideration by the
President and the Commissioners. BEPA runs three external expert groups advising the
President of the European Commission. One is the Group of Economic Policy Analysis
(GEPA), a body made up of top European economists.
The European Commission - under the responsibility of the Commission departments for
Trade and External Relations - is in the process of reviewing its policy strategy as regards
China. A request was made for BEPA to write a report (i) reviewing where China stands on its
development path, (ii) assessing what challenges it is facing, and (iii) analysing what this
implies for Europe and its policy stance. Subsequent to that request BEPA organised a GEPA
meeting on China in December. This report is a follow-up to that meeting and provides a
background for reviewing the EU`s China strategy.
In drafting the report, the authors have benefited from prior research and work carried out by
other Commission departments, notably Economic and Financial Affairs, Enterprise and
Industry, Environment, Trade, and External Relations. Specific reports and notes by these
services have been used as references throughout the report. The policy conclusions of the
report were discussed with members of the President`s Office, the External Relations and
Trade departments. The authors also benefited from comments by GEPA members and BEPA
colleagues. Any remaining errors are the responsibility of the authors.
The opinions expressed in this paper are solely those of its authors and do not necessarily
reflect the views of the European Commission.
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Abstract
During the last decade, China has become a major global economic and political player.
China`s economic development has been extraordinary; with average annual GDP growth rates
close to 10%, it has become the third largest exporter globally. Nevertheless, the GDP per
capita numbers underline how far China`s standard of living is still lagging behind and how far
distant the goal of a well-off society¨, emphasising a more social and environmentally
friendly path to development, still is. In line with China`s economic rise, the country has come
to occupy a prominent place on the EU policy agenda. China is now the EU`s second most
important trading partner, after the US, while the EU has become China`s top trading partner.
This report will first analyse what forces have been driving China`s current development. The
second part will try to identify how China will evolve in the future and what challenges to its
long-term sustainable development it is facing. The final part analyses the impact of China`s
current and future development for the EU and its policy stance. It concludes with
recommendations for an EU policy on China.
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PREFACE
In the course of the last decade, China has become a major global economic and political
player. This development has been triggered primarily by the economic policy changes
launched in the late 1970s, gradually opening up the economy to the forces of global markets.
This process has been unquestionably positive for Chinese citizens, who are leaving behind
decades of poverty. Since the start of the reforms, national income (GDP) has grown at an
average annual rate close to 10%. China has accordingly closed a substantial part of the gap
with the developed world. In 2004, China is the third biggest economy in terms of GDP
(adjusted to differences in purchasing power) after the US and the EU and way above Japan
and India and a major trader on world markets. Nevertheless, it still has a long way to go.
Despite the specific sectoral segments in which China is competing on a global scale, the
economy as a whole is still struggling with underdevelopment and poverty, especially in the
western provinces. Working to close the remaining gap will require that China, while opting
for a more social and environmental friendly, harmonious¨ path to development, be
nonetheless able to maintain the dynamics of its recent growth performance.
But beyond the internal challenges, China`s rise raises important questions for the international
community. Over the last decades and under unchanging single-party rule, China has evolved
from a revolutionary state to a relatively status quo state and from diplomatic isolation to an
impressive expansion of its diplomatic commitments. Along the road China has developed at
least a dual identity, with regular real tensions between the two identities; one is the sovereign
nation, aiming to establish a rich state and strong army¨ so as not to be humiliated again, and
the other is the self-proclaimed responsible major power¨, whose integration in the
international community is quite remarkable having regard to the country`s level of
development. China has indeed claimed a prominent place on the global agenda and more
specifically on the EU`s policy agenda. The debates around the arms embargo and textiles
imports in 2005 illustrate how important China has become for Europe, both as an economic
and as a geopolitical player. China is now the EU`s second most important trading partner,
after the US, while the EU has become China`s top trading partner.
In drafting this report, the authors set out to answer three questions: (i) Where does China stand
on its development path? (ii) What challenges is it facing? (iii) What does China`s rise imply
for the world in general and the EU and its policy stance in particular? Given the extent to
which politics and economics are increasingly indivisible, the report will both consider the
economic as well as the political dimension of China`s development. Accordingly, Part I of
this report analyses where China is today. It analyses China`s political system and the sources
of its current economic growth. It continues with an analysis of China`s position in the world
economy and its evolving foreign policy. Part II reviews a number of the significant
challenges to its long-term sustainable development, including challenges to the macro-
economic policy framework, the financial and production system, public finances, innovative
capacity, labour markets, social cohesion, environment and the political and legal system.
Finally, after taking an in-depth look at the strengths and weaknesses of the Chinese
development process, Part III analyses the impact of China`s continued rise for the EU.
Starting off with an analysis of the economic impact on the EU, it continues with a description
of the EU`s current policy vis-à-vis China, concluding with recommendations for a future EU
China policy.
The result is, unsurprisingly, a lengthy report. A few remarks to assist the intrepid reader: the
Key Questions and Policy Recommendations of this report are summarised in the box on the
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following three pages. The more detailed findings of the three parts of the report underpinning
our Key Policy Conclusions are found in the Executive Summary. For readers interested only in
specific issues, the Table of Content lists the different chapters of each part. Furthermore, each
of the Three Parts is preceded by a short summary providing the gist of the argument and an
outline clearly indicating the focus of each chapter.
The authors, Brussels, July 2006
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Table of contents
PREFACE................................................................................................................................................................ IV
KEY QUESTIONS AND POLICY RECOMMENDATIONS ........................................................................... IX
EXECUTIVE SUMMARY ................................................................................................................................. XIII
1. THE POLITICAL SYSTEM...........................................................................................................................2
1.1. SOCIALIST DEMOCRACY¨ WITH CHINESE CHARACTERISTICS ..................................................................2
1.2. ADMINISTRATIVE DIVISION.......................................................................................................................4
1.3. MAIN POLITICAL INSTITUTIONS.................................................................................................................5
1.3.1. The Chinese Communist Party (CCP).................................................................................................6
1.3.2. The legislative body. the National People's Congress (NPC) ............................................................9
1.3.3. The Presidency...................................................................................................................................10
1.3.4. The executive body. the State Council...............................................................................................11
1.3.5. The leading small groups (lingdao xiaozu) .......................................................................................11
1.3.6. The Central Military Commission .....................................................................................................11
1.3.7. The Judiciary .....................................................................................................................................12
1.4. THE PEOPLE`S LIBERATION ARMY (PLA)...............................................................................................12
2. THE SOURCES OF ECONOMIC GROWTH...........................................................................................15
2.1. THE ECONOMIC POLICY FRAMEWORK FOR GROWTH................................................................................16
2.2. THE CONTRIBUTION OF CAPITAL, LABOUR AND OTHER FACTORS TO GROWTH........................................18
2.3. THE PRIVATE SECTOR..............................................................................................................................21
2.4. FOREIGN DIRECT INVESTMENT ...............................................................................................................23
2.4.1. The political framework for FDI .......................................................................................................23
2.4.2. FDI Inflows and the Modernisation of China's Industry ..................................................................24
2.5. CHINA`S HIGH-TECH INDUSTRIES AND THE ROLE OF FDI ........................................................................29
2.6. CHINA`S SCIENCE &TECHNOLOGY.........................................................................................................31
2.6.1. China's striving for S&T development ..............................................................................................31
2.6.2. Government funding of S&T..............................................................................................................32
2.6.3. Human Capital for S&T. tertiary education .....................................................................................33
2.6.4. China's S&T performance.................................................................................................................35
2.7. CONCLUSION...........................................................................................................................................37
3. CHINA`S POSITION IN THE WORLD ECONOMY...............................................................................40
3.1. CHINA`S POSITION IN GLOBAL TRADE ....................................................................................................40
3.1.1. China's Trade by geographical area.................................................................................................41
3.1.2. China's comparative advantage in world markets............................................................................44
3.1.3. China's role in the international division of labour..........................................................................47
3.2. OUTWARD-BOUND FDI - ONE STEP FURTHER TOWARDS GLOBAL SIGNIFICANCE................................49
3.3. THE IMPACT OF GROWING ENERGY AND RAW MATERIALS DEMAND IN CHINA .......................................50
3.4. CONCLUSION...........................................................................................................................................51
4. CHINA`S EVOLVING FOREIGN POLICY..............................................................................................53
4.1. WORLD VIEWS OF CHINA ........................................................................................................................54
4.2. CHINA`S REASSURANCE POLICY..............................................................................................................56
4.3. THE REGIONAL OPENING-UP OF CHINA`S FOREIGN POLICY .....................................................................58
4.3.1. Central Asia.......................................................................................................................................58
4.3.2. South-east Asia ..................................................................................................................................61
4.3.3. The limits of China's influence over Asia..........................................................................................61
4.4. CHINA`S GO GLOBAL¨ ENERGY POLICY .................................................................................................70
4.4.1. Africa .................................................................................................................................................70
4.4.2. Middle East ........................................................................................................................................73
4.4.3. Latin America ....................................................................................................................................73
4.5. CONCLUSION...........................................................................................................................................74
PART I: WHERE DOES CHINA STAND TODAY? ............................................................................................. 1
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5. SECURING A BALANCED MACRO-ECONOMIC ENVIRONMENT.................................................76
6. UPGRADING THE FINANCIAL SYSTEM...............................................................................................78
6.1. BANK FINANCE........................................................................................................................................78
6.1.1. A large and growing banking system ................................................................................................79
6.1.2. Addressing precarious financial positions ........................................................................................80
6.1.3. Consolidating a commercial culture .................................................................................................82
6.1.4. Foreign presence ...............................................................................................................................82
6.2. CAPITAL MARKETS ..................................................................................................................................84
6.2.1. Equity markets ...................................................................................................................................85
6.2.2. Bond markets .....................................................................................................................................89
6.2.3. Investment funds ................................................................................................................................89
6.3. INFORMAL FINANCE.................................................................................................................................90
6.4. CONCLUSION...........................................................................................................................................91
7. REFORMING THE PRODUCTION SYSTEM.........................................................................................92
7.1. REFORMING CHINA`S PUBLIC SECTOR.....................................................................................................92
7.2. REFORMING CHINA`S PRIVATE SECTOR...................................................................................................94
7.2.1. Financial constraints .........................................................................................................................94
7.2.2. Barriers to entry ................................................................................................................................95
7.2.3. Barriers to exit ...................................................................................................................................95
7.2.4. Legal barriers to operation and expansion.......................................................................................95
7.2.5. Barriers to trade ................................................................................................................................96
7.2.6. Barriers to competition......................................................................................................................96
7.3. CONCLUSION...........................................................................................................................................98
8. REFOCUS PUBLIC FINANCES .................................................................................................................99
8.1. RAISING REVENUE...................................................................................................................................99
8.2. ALLOCATING REVENUE .........................................................................................................................100
8.3. SPENDING..............................................................................................................................................102
8.4. BUDGET BALANCE.................................................................................................................................103
8.5. REFOCUSING EXPENDITURE TO ADDRESS SOCIAL CHALLENGES AND PROVIDE A BETTER FOUNDATION
FOR GROWTH........................................................................................................................................................103
8.5.1. Social insurance...............................................................................................................................104
8.5.2. Education.........................................................................................................................................106
9. DEVELOPING CHINA`S INNOVATIVE POTENTIAL .......................................................................108
9.1. CHINA`S STRENGTHS IN BUILDING INNOVATIVE CAPACITY...................................................................108
9.2. CHINA`S CHALLENGES IN BUILDING INNOVATIVE CAPACITY................................................................109
9.2.1. Developing the public research infrastructure................................................................................109
9.2.2. Developing private research............................................................................................................111
9.3. CONCLUSION.........................................................................................................................................113
10. ABSORBING SURPLUS LABOUR......................................................................................................114
10.1. TRENDS IN CHINA`S LABOUR MARKET: RURAL VS. URBAN EMPLOYMENT...........................................114
10.2. UNEMPLOYMENT: AN UNDERSTATED PHENOMENON?...........................................................................116
10.3. PROJECTIONS ON CHINA`S LABOUR MARKET: CAN DEMAND MEET SUPPLY?.........................................117
10.4. LABOUR MARKET REFORMS ..................................................................................................................118
10.5. CONCLUSION.........................................................................................................................................119
11. ADDRESSING THE INCREASE IN INEQUALITY .........................................................................
11.1. INCREASING DISPARITIES IN ECONOMIC OUTCOMES..............................................................................121
11.2. REASONS FOR INCREASES IN DISPARITIES .............................................................................................122
11.3. CONCLUSION.........................................................................................................................................124
12. ADDRESSING ENVIRONMENTAL CHALLENGES.......................................................................125
12.1. POLLUTION CONTROL............................................................................................................................125
12.2. EFFICIENT USE OF NATIONAL RESOURCES .............................................................................................125
13. ADAPTING CHINA`S POLITICAL AND LEGAL INSTITUTIONS TO A TRANSFORMED
SOCIETY................................................................................................................................................................126
13.1. A CHANGING SOCIETY...........................................................................................................................126
PART II: WHAT CHALLENGES IS CHINA FACING? ................................................................................... 75
120
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13.1.1. Emergence of a middle-class ......................................................................................................127
13.1.2. The young urban entrepreneurs..................................................................................................128
13.1.3. The return of foreign-educated Chinese .....................................................................................128
13.1.4. The emergence of a new political generation.............................................................................129
13.2. ACOMMUNIST PARTY IN SEARCH OF LEGITIMACY ...............................................................................130
13.2.1. Nationalism.................................................................................................................................130
13.2.2. Inner party democracy................................................................................................................131
13.2.3. Grassroots democracy ................................................................................................................131
13.2.4. China's civil society....................................................................................................................132
13.3. A DUAL APPROACH TO SOCIETY ............................................................................................................134
13.3.1. The caring approach...................................................................................................................134
13.3.2. The repressive approach.............................................................................................................135
13.4. IMPROVING THE LEGAL SYSTEM............................................................................................................136
13.4.1. From rule of man to rule of law..................................................................................................136
13.4.2. Enforcement and implementation ...............................................................................................136
13.5. CONCLUSION.........................................................................................................................................137
14. THE ECONOMIC IMPACT OF CHINA`S RISE...............................................................................140
14.1. EU TRADE AND CHINA..........................................................................................................................140
14.1.1. Overall Trade Position ...............................................................................................................140
14.1.2. Trade Position by Member State ................................................................................................142
14.1.3. Trade Position by Sector.............................................................................................................142
14.1.4. EU-China competitiveness trends...............................................................................................145
14.2. FDI FROM EUROPE INTO CHINA............................................................................................................147
14.3. TRADE PERFORMANCE OF FOREIGN FIRMS INVESTING IN CHINA...........................................................149
14.4. CONCLUSION.........................................................................................................................................150
15. CURRENT EU-CHINA POLICIES......................................................................................................151
15.1. CURRENT EC OBJECTIVES AND INSTITUTIONAL SET-UP ........................................................................151
15.2. EU- CHINA TRADE POLICY...................................................................................................................153
15.3. EU AND CHINA: TWO VISIONS OF FOREIGN POLICY...............................................................................154
15.3.1. Human rights ..............................................................................................................................155
15.3.2. Good governance........................................................................................................................155
15.3.3. Multilateralism............................................................................................................................156
15.3.4. International order......................................................................................................................156
15.4. THE EU, ITS MEMBER STATES AND CHINA: A COMPLEX PICTURE ........................................................156
15.5. THE EU, THE US AND CHINA: THE RISKS OF A TRIANGULAR RELATION ...............................................157
15.5.1. The EU and the US - two different perspectives on China ........................................................157
15.5.2. The EU's and the United States' shared interests towards China .............................................158
16. EU POLICY OBJECTIVES...................................................................................................................160
16.1. BASE POLICYMAKING ON A SOUND UNDERSTANDING OF CHINA...........................................................160
16.2. HELP CHINA SUCCEED...........................................................................................................................162
16.3. MAXIMISE ECONOMIC OPPORTUNITIES AND MINIMISE RISKS FOR EU FIRMS.........................................162
16.4. IMPROVE EUROPE`S CAPACITY TO ADAPT .............................................................................................163
16.4.1. Improve competitiveness.............................................................................................................163
16.4.2. Facilitate transition ....................................................................................................................164
16.5. MAINTAIN AND PROMOTE AN OPEN WORLD ECONOMY.........................................................................164
16.6. PROMOTE 'HARMONIOUS` INTERNATIONAL RELATIONS........................................................................166
REFERENCES.......................................................................................................................................................16
LIST OF TABLES, GRAPHS AND BOXES......................................................................................................172
LIST OF ACRONYMS .........................................................................................................................................174
PART III: WHAT CHALLENGES IS EUROPE FACING? ............................................................................ 139
9
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KEY QUESTIONS AND POLICY RECOMMENDATIONS
Where does China stand on its development path?
Over the last three decades China has experienced a remarkable transformation. Since the
comprehensive political and economic reforms initiated in the late 1970s, and which
have achieved full speed since 1992, the economy has grown by more than 9% per year
on average, and a large part of the economy is now in private hands. An important
component of China`s development is its integration in the global economy. China has
captured an increasing part of world trade and investment flows. It has become the third
largest exporter in the world. In some important areas, like ICT, China already became
the largest exporter.
Notwithstanding this impressive performance, China is facing daunting challenges.
Continuing to pull China`s population out of poverty requires sustained growth for a long
period of time. Moreover, China`s long-term growth strategy calls not only for more
wealth, but for a harmonious¨ society where wealth is more evenly distributed and
where growth is based on technology, economic efficiency and low consumption of
natural resources.
Will China succeed in addressing the challenges?
At this stage, it is difficult to know whether the foundations underpinning the current
performance are sufficiently sound to deliver this vision of a harmonious¨ society. In
order to overcome these challenges, not only do the reforms agreed upon so far need to
be effectively implemented; they also need to be broader and deeper. A number of areas
warrant particular attention in this respect, such as continuing reforms of the financial,
product and labour markets and improvements to China`s innovative and legal capacity.
Overall, the biggest challenge for China is that the challenges that have been pinpointed
cannot be tackled in isolation. Instead, they need to be dealt with systemically. If not,
failure to progress sufficiently in one area may hamper progress in other areas.
Whether the current political leadership will be able and willing to address the challenges
is uncertain. Addressing the future set of challenges requires reforms that will
increasingly go to the heart of the current system. Changes are likely to be of such a
fundamental nature that they will eventually restrain the leadership`s direct control and
stewardship of the economy and society. The reforms adopted so far have been managed
within the current autocratic institutional setting. The remaining challenges, and the way
they are addressed, illustrate a fundamental issue: how far can a one-party autocratic state
liberalise the economy without further liberalising society and the political system? For
example, dealing with the dysfunctional banking system requires allowing more private
ownership of banks. This would, however, remove an important policy tool from the
government`s hands. Equally, any drive to address regional inequalities requires the
liberalisation of the currently fragmented labour market, thereby allowing people to seek
economic opportunities where they are. That would, however, disable the government`s
close control of the population. Moreover, as private firms become more common, China
needs to set up the normal checks on companies` behaviour, e.g. as regards collusion or
abuse of dominant positions. However, the effective enforcement of competition policies
requires an independent competition authority, which would mean relinquishing control
of yet another industrial policy tool.
In many respects China is very well placed to meet future challenges. The country is
endowed with favourable preconditions for growth, the most important being the huge
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pool of human capital on which it can draw as input for production and as consumers to
sell to. The large population displays a strong entrepreneurial¨ spirit and a high desire to
invest in the future, as illustrated by the high levels of private expenditure on education.
Both dimensions reflect a desire for individual advancement, which has been an
important driver of current economic performance in China. A remarkable feature of
China`s rise since 1992 has been the soundness of its economic management. China`s
leadership has handled major shocks, like the Asian financial crisis and the WTO
accession, astutely. Furthermore, the state and civil society have found fairly innovative
ways of dealing with the tension between a liberalised economy and a controlled society.
So far, while falling short of anything close to Western democratic standards,
nevertheless some kind of basic dialogue seems to have been established. The current
leadership has been prepared to allow different forms of limited checks on its powers,
such as local political pluralism, that offer some form of safety valve for political
discontent. Moreover, in the wake of market liberalisation and WTO entry, the rule of
law is increasingly gaining ground. Citizens increasingly turn to the judiciary as a way of
seeking redress if they are unhappy with certain acts and decisions by the state.
But what about the willingness of political leaders to endorse more profound political
reforms in the future? So far the current political leadership has not shown any openness
to contemplate more far-reaching reforms, not even in terms of relinquishing significant
control, let alone in terms of freedom of expression, association and the like.
Interestingly, this slow pace of political reform seems to have encountered an
accommodating Chinese society. This can undoubtedly be related to policymakers`
ability to deliver economic growth. As long as the current system manages to deliver, its
political acceptability¨, if not exactly legitimacy, is likely to remain sufficiently high in
the eyes of citizens.
However, how citizens` preferences will evolve over time as China develops is an
unknown. Will people remain willing to sacrifice political freedoms, such as freedom of
expression and association, for expanding economic opportunities and enrichment? Or
will they at some stage want both? And what if the economic growth engine starts to
splutter? This could happen for various reasons, e.g. failing reforms, unfavourable
external economic conditions such as a worldwide recession, or geopolitical hot-spots
like the Taiwan issue turning into a military scenario.
The current Chinese economy remains highly sensitive to these inside and outside
conditions. Overall, what is clear is that by liberalising the economy, China has set in
motion forces that are quietly permeating the whole of society. The current leadership is
fully aware of the challenges it faces in the short, medium and long term. The question is
whether China will be able to pursue the right reform trajectory and choose the right
speed of reform in future. The noteworthy past track record of economic management
should engender some significant degree of confidence for the future, at least. What is
clear is that economic reforms will come first, political reforms second. A more
democratic China may well emerge in the future, but it will not necessarily be a liberal
democratic Western-type political model.
Where China is going internally will have an impact externally. So far, China`s foreign
policy has been mostly devoted to ensuring continued economic growth and
development. In the longer term it is uncertain what role China wants to play on the
world scene and accordingly what influence it will exercise. The current leadership`s
resort to nationalism internally as the glue to bind together an increasingly diverse
society may become a source of concern for the outside world.
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What are the implications for Europe and its policy stance?
Where China is going matters for Europe. In line with its economic rise, the country has
taken an increasingly prominent place on the EU policy agenda. The EU is China`s top
trading partner, while China is the EU`s second most important trading partner (after the
US). That this is not always perceived as an opportunity is indicated by the discussions
over trade in textiles and the recent decision to impose anti-dumping measures on certain
imports of shoes from China. That China`s rise also has a political and security
dimension was illustrated by the fractious debate in 2005 on whether or not to do away
with the arms embargo that has been in place since the Tiananmen Square incidents of
1989. So given the uncertainty of China`s current and future course and the importance
for the EU of China`s smooth development and integration into the world economy and
the international system, we need to understand China better. More particularly:
The EU should base policymaking on a sound understanding of China: the EU needs to
continuously assess and report on China`s development process and where it wants to go.
More fundamentally, however, improving our understanding and knowledge of China
requires a refocusing of our local presence and a strengthening of the analytical capacity
in Brussels. As specialised knowledge about contemporary China is weak in Europe, this
requires a coherent supply response.
The EU should cooperate with China in its development process: an open, growing China
is of major benefit to Europe. It is therefore in our interest to assist China in addressing
the challenges it is facing in areas where we have useful experience. The EU has
traditionally focused on assisting the internal transition and reform process, by helping to
improve governance, and strengthen civil society and the rule of law. The EU has
several instruments at its disposal for developing this cooperative engagement strategy
(e.g. development assistance and international cooperation in S&T). These should be put
to strategic use, focusing on policy areas of mutual interest and shared importance.
Furthermore, China`s experience with sequencing a complementary set of reforms may
be instructive for EU policymakers.
The EU should improve its capacity to adapt: the challenge is to improve the European
economy so that globalisation and competition from China are no longer a threat to jobs,
but an opportunity for growth in the EU. To achieve this, the European economy needs to
improve its adaptive capacity. Policy should therefore (i) improve EU competitiveness
and (ii) facilitate transition. This is a vast agenda, but the necessary policy responses are
well-known and embodied in the Lisbon Strategy. These policies need to be
implemented.
The EU should be able to maximise economic opportunities and minimise risks: The
Chinese market represents a tremendous opportunity for EU firms. But while there is the
potential for a win-win situation, there are many uncertainties. China is a market and a
society characterised by rapid flux, where the institutional framework underpinning the
economy has not fully kept up the pace, calling for a continued concern of policymakers
to eliminate barriers to operations for (foreign) companies.
The EU should continue to promote an open world economy: The EU should keep its
markets open in order to allow other countries - including China - to benefit from the
opportunities associated with economic openness. But this openness should be reciprocal.
An open world economy is in China`s best interest: an open trade and investment
environment will allow China to capitalise fully on its relative strength. But challenges
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remain in some areas such as intellectual property rights, standards, public procurement,
national treatment and market access in strategic sectors¨.
The EU should promote 'harmonious` international relations: Apart from enmeshing
China in the institutions underpinning the world economy, it is also important to anchor
China in the wider international system. The EU should build on China`s desire for a
stable environment to pursue and sustain its economic growth. This is a period when the
EU should be encouraging China to play a more responsible and constructive role in
world affairs and not only to accept but also to implement international commitments;
The EU should prod its Member States into cooperating more on China issues. To
engage more effectively with China, the EU needs to establish a more visible political
presence. While frequent contacts between EU and Chinesepolicy makers are useful,
they would be more effective if the EU were able to speak with one voice. Particularly
on trade and FDI issues, Member States too often see themselves in competition for
China`s attention rather than in cooperation. Naturally, the EU`s problems in this respect
are generic. Building up a common strategic outlook and vision between Member States
on external policy is a long-term endeavour. It is a worthwhile one, though, particularly
with respect to China. Divergences clearly sow confusion and decrease the EU`s
influence in China and the East Asian region at large.
The EU should embrace the potentially unsettling EU-US-China triangle: Europe and the
United States have many shared interests. Both agree that the most important issue is to
manage China`s smooth and peaceful integration into the established global system. They
also share the hope that China will rise to become a responsible major power, a reliable
economic partner and an increasingly pluralistic and democratic state. Nevertheless,
what is at stake is different for the EU and the United States. That is primarily because
the EU, unlike the US, has no significant security strategic interests in the region, nor is it
expected to act as a regional security guarantor. However, the EU should further develop
a security perspective on China. For example, as the question of how the EU would react
to a possible crisis in the Taiwanese strait should be seriously considered.
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EXECUTIVE SUMMARY
China`s future course is uncertain. But what is clear is that the direction it takes matters
for Europe. It follows that a better understanding of China is an important precondition
for a sound EU-China policy. This report is an attempt to understand better where China
stands on its growth path and to identify what challenges it is facing in the future, with a
view to assessing assess what China`s current and future development implies for the
world at large, and particularly for the EU and its policy stance. This summary reviews
the main findings of the report, which have underpinned our key policy
recommendations for Europe.
Part I: Where does China stand today?
The first part of the report describes how the political system currently looks like;
reviews the sources of current economic growth; examines China`s position in the world
economy; and finally, considers how China`s conduct in the foreign policy arena has
evolved as a result of its increasing economic might. When looking at today`s China one
should not forget China`s past of pride and humiliation¨. China is not emerging¨ as a
major economic power, but rather re-emerging¨, having accounted for 30% of global
GDP at the start of the 18
th
century. Although this may seem ancient history, the
Chinese share the dream of a strong China, and China`s leaders have consistently
endorsed the core nationalist mission of ending China`s national humiliation.
China's political system
China is a one-party state with a highly centralised political organisation. The core
leadership body is the Chinese Communist Party (CCP)`s Political Bureau Standing
Committee. Currently composed of nine members, it reflects the continuation of
collective leadership into the so-called Fourth Generation of leaders. The transfer of
power from the previous generation started in 2002 and was remarkably smooth. Hu
Jintao now holds the three most important posts in China`s political system: CCP
General Secretary, President of State, and Chairman of the Central Military Commission.
A broad political consensus seems to exist on the fact that the Chinese Communist Party
(CCP) has to be kept in power, to ensure political stability. However, this critically
depends on the CCP`s ability to govern an increasingly sophisticated society and to deal
with the challenges it faces. Today the Party draws its legitimacy and relevance basically
from a mixture of nationalism and the delivery of economic growth. The CCP leadership
has so far shown a significant capacity to adapt to changing times. There is notably an
acute awareness of the importance of gaining a better understanding of the world and of
working out more sophisticated positions, in particular in multilateral organisations.
Thus, if the policy process remains basically top-down, it is nonetheless increasingly
open to external inputs. Furthermore, the new leadership led by President Hu Jintao and
Premier Wen Jiabao seems to be ready to address the two major challenges to the
stability of the existing political system, i.e. endemic and rampant official corruption and
rising social unrest. It remains to be seen if they will match words with deeds.
One of the most important features of China`s recent political evolution has been the
reform of its legal system. China has moved a long way from the traditional rule of
man¨ legal approach. However, the country`s progress towards a genuine modern legal
system, i.e. the rule of law, is mixed.
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The sources of China's current growth
China is endowed with favourable conditions for economic development and growth. A
huge supply of labour, an entrepreneurial drive, a very high savings rate, and a large
domestic market all offer opportunities for economic development. However, particularly
important for instigating the current extraordinary growth performance have been the
reforms to the institutional framework underpinning the economy. China has, since the
late 1970s, but particularly since 1992, embarked on a comprehensive programme of
economic reforms, embodied by the open door¨ policy, which decisively opened up the
Chinese economy to world markets by encouraging foreign investment and trade. The
accession to the WTO in 2001 firmly anchored China in the world forum and provided a
further impetus for the reform process.
The accumulation of capital, financed for the most part by personal sector savings, has
been crucial in driving the increase in GDP. Most of this capital spending is investments
in fixed assets (capital construction), reflecting the importance of the industrial sector to
China`s economic structure. The contribution of employment to overall growth, on the
other hand, has been very modest, due to the restructuring of employment in the highly
inefficient agricultural sector and the State Owned Enterprises. Education has played an
increasing role, particularly since the mid 1990s, with higher education in particular
improving the skill level of the Chinese labour force. Finally, China`s growth has been
supported by productivity gains from the rise of the private sector in the economy. This
has improved overall economic performance, as the private sector, domestic and foreign,
is more efficient than the state controlled sector. An important factor behind the higher
productivity of private sector firms is their participation in world markets. Foreign
Direct Investment was the catalyst which brought China`s economy back onto the
global stage. Initially, FDI was mostly aimed at developing export oriented activities.
During this early stage, China benefited from the import of capital, employment creation
and exports, and from the modern technology brought in by the foreign firms. During
subsequent stages of development, foreign investors became more motivated by market
access. Currently, China is trading access to the Chinese market against foreign
investors` technological and organisational know-how.
Although the growth in FDI into China has been impressive, a closer look at the data
lends more perspective to the importance of FDI for the sustained development of the
Chinese economy. The bulk of China`s massive FDI inflows have not originated in the
world economy`s centres of technological growth. Hong Kong, Taiwan and other
countries in South East Asia have been the most important investors in China.
Furthermore, China`s FDI inflows have been heavily concentrated in the coastal
provinces, with little sign of dispersion towards western China. Similarly, the openness
to FDI remains heavily regulated. Sectors that have put restrictions on foreign
investments include cars, petrochemicals, financial services, air transport, media and
electricity.
China`s economic policymakers are aware that having China as the global centre for
labour-intensive, low-skilled processing manufacturing will not be sufficient to sustain
growth performance in the longer term. The current focus of China`s industrial policy is
on promoting and establishing higher value added, technology-intensive industries and
the country`s own indigenous (innovative) capacity.
Ch/na's H/gh-Tech. The contribution of high-tech industries (particularly ICT
sectors) to manufacturing value added has increased to ratios comparable with most
Western economies. Foreign firms account for more than half of the value added in
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China`s high-tech industries. Nevertheless, their share in R&D expenditures has not
been in line with their share in value added. The reluctance to locate R&D in China is
due to insufficient protection of intellectual property. Nevertheless, surveys show that
foreign high-tech firms plan to increasingly locate R&D in China. Due to WTO-
related reforms, foreign high-tech enterprises are now in many cases allowed to
establish wholly foreign-owned subsidiaries in China, which are more attractive than
joint ventures for conducting R&D, since they represent a better way of keeping core
know-how proprietary.
Ch/na's Sc/ence and Techna/agv. Gross expenditure on R&D (GERD) as a share of
national income has increased substantially and is planned to increase to levels
comparable to the West. Although private (local) investment in R&D is growing, the
Chinese government remains an important financer of research. This public spending
is highly focused on areas where China can force the pace of development: IT,
energy, biotech, but also national security (aerospace and laser technology) and
frontier research. An important component of S&T growth in China is its huge pool
of human capital for R&D, especially scientists and engineers. As a result of the
growth in these S&T inputs, China`s S&T output - as measured by publications and
patents - is growing, albeit from a low base.
China's position in the world economy
As China has gradually become an integral part of the world economy, its economic
weight has been increasingly felt by other participants. China has already become a
major trading nation in the world economy. Both on the import and export side, China`s
trade has an eminent South-East Asian regional dimension. An important share of this
regional trade is intra-company trade on the part of multinational firms building their
value added chain regionally, reflecting the economic integration of the region (notably
Taiwan, Hong Kong and PRC). Overall, China has managed to export more than it
imports, thus keeping a trade surplus, especially with the US and the EU. The large
deficits in all areas of intermediate trade and surpluses in final goods suggest that China
is still mainly an assembly country. A few trends are nevertheless noteworthy:
Campara(/re adran(age /n ICT. China`s future position is very likely to shift away
from its role as pure assembly country. While resource-intensive, low-tech and
labour-intensive products lay at the core of export activities in the 1980s, China`s
export structure has since changed dramatically. China has improved its comparative
advantage - as illustrated by positive and strongly increasing Relative Comparative
Advantage (RCA) values - in medium-tech and more capital-intensive products,
most notably ICT. In 2004, China overtook the US to become the world`s leading
exporter of ICT goods. At the same time, it is shifting its import demand. While
China previously relied on electronic components (e.g. computer chips) imported
from the US and the EU, they are now increasingly being produced in China and/or
sourced from other Asian countries. As a consequence, China runs a trade surplus in
ICT, both with the US and with the EU, and this surplus continues to rise.
Oa(ward FDI //m/(ed ba( /ncreas/ng. FDI could provide a way for large Chinese
companies to expand abroad and gain access to distribution channels, trademarks and
technology. However, in comparison to the huge flows of inward-bound FDI,
outward-bound FDI remains minor. Nevertheless, rising outward investment by
Chinese enterprises signals a new stage in the country`s integration into the global
economy. Most of the investment coming out of China is still motivated by ensuring
access to resources. Nevertheless, commercial and strategic interests of individual
enterprises are increasingly driving outward FDI activities.
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Ch/na's graw/ng demand far energv and raw ma(er/a/s. High growth rates and
rising importance in global terms inevitably mean that developments on the Chinese
market are having an ever stronger influence on global demand, supply and prices.
This is illustrated by developments in world commodity and energy markets. China`s
increasing oil consumption has been covered almost entirely by imports. The
suddenness of the change in certain sectors may also imply that a smooth supply
response cannot necessarily be assured. At this stage, it is impossible to make
predictions about the impact of Chinese import growth on prices.
China's evolving foreign policy
With China`s integration into the world economy comes the inevitable counterpart:
increasing dependence on external markets, including foreign energy resources. At the
same time, China`s increasing economic wealth, coupled to its status as a permanent
member of the UN Security Council and its nuclear capability, is giving the country a
growing influence on the foreign policy scene.
China is very much aware of the concerns raised by its rapid development, and is at pains
to reassure the international community that its rise is a long-haul peaceful process based
on a cooperative approach which is respectful of the current international system and not
out to challenge it. Should China put an end to this peace and development line, this
would signal a fundamental and worrying policy shift.
China`s foreign policy approach is mainly based on the Five Principles for Peaceful
Coexistence, which include respect for sovereignty and territorial integrity, and non-
interference in internal affairs. Its current approach to foreign policy is determined
mainly by its strategy of sustaining a high level of economic development and prosperity,
to protect its key economic assets, and to maintain a stable and safe regional and internal
security environment.
Since the mid 1990s China, both inspired by its vision of a multipolar world and
driven by concern for its reputation and image as a high status power, has increasingly
become active in a number of regional and multilateral organisations, while not
neglecting bilateral ties. China`s most significant foreign policy development and
success is certainly its proactive regional policy, which correlates with the growing
economic integration of the region. Regional interdependence is probably conducive
to a more stable environment. However, the region remains very unstable, with
hotspots such as Taiwan, the Korean Peninsula, and a number of long-standing
maritime disputes. As China`s key economic assets have tended to become
concentrated along its eastern and southern coastline, its vulnerability to maritime
threats has increased. In this context China`s lack of transparency over its military
build-up is a matter of concern for its neighbours. Furthermore, while the countries of
the region are very diverse - with differing political systems and different levels of
development - no clear regional leadership has emerged so far. China, Japan and
India, not to mention the United States, all remain important players in the region.
China`s go global¨ policy is basically an economically driven policy which is pushing it
to search for natural resources abroad, in Africa, the Middle East and Latin America.
This policy may alleviate some of the problems being encountered by a number of
countries, especially in Africa. However, the energy issue is much more than an
economic issue. China`s foreign policy vis-à-vis these countries, which gives little room
to considerations other than China`s own pragmatic economic interests, poses notably the
risk of undermining the capacity of the international community to influence countries in
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terms of good governance, human rights and political freedom. This may ultimately
undermine China`s own efforts to be seen as a responsible global power.
Part II: What challenges is China facing?
In spite of China`s impressive economic development since the launch of the reform
process, the remaining objectives are daunting. Pulling all of China`s population out of
poverty will require sustained high growth over a long period of time. Moreover, China`s
long-term growth strategy calls not only for more wealth, but for a harmonious society¨
where wealth is more evenly distributed among all levels of society, and growth is based
more on technology and efficiency of input use. While overall growth remains high, it is
far from certain that the economic foundations are sufficiently sound to ensure that this
objective can be achieved. The slowdown in productivity growth in recent years reflects
a number of residual challenges, attributed to insufficient flexibility in labour, capital and
product markets to stimulate productivity. In order to overcome these, not only do agreed
reforms need to be effectively implemented - broader and deeper reforms are needed. A
number of areas warrant particular attention in this respect:
Macra-ecanam/c cha//enges. An ongoing challenge in a rapidly growing economy is
the provision of a stable macro-economic climate. While inflation has been relatively
low, it has been volatile. Domestic monetary policy has not been very successful in
managing aggregate demand. The existence of a relatively fixed rate of exchange
against the dollar has exposed the economy to inflationary or deflationary impulses
stemming from fluctuations in the effective exchange rate.
Refacas/ng pab//c f/nances. Public finances have grown faster than the economy, but
remain low by international standards. They are by and large in a healthy state, with a
limited budget deficit and low national debt. However, (i) expenditure is not
sufficiently focused on China`s upcoming challenges, especially on social insurance
(pensions and health) and education, (ii) revenue is often raised in a distortive and
opaque manner, and (iii) poorer regions and counties have difficulties in financing
their expenditure obligations.
Refarm/ng f/nanc/a/ marke(s. Probably the greatest liability to the Chinese
development process is the undeveloped financial system and the poor performance of
the banking sector and its dismal relationship with the state-owned enterprise sector in
particular. The banking sector is highly successful in pooling savings, but assigning
these savings to investment projects conducted by state-owned enterprises amounts to
their annihilation. A large share of credit allocated by the banking sector has turned
into non-performing loans (NPL). China has implemented significant reforms to its
financial sector, including opening up to foreign ownership. However, it remains to be
seen whether these reforms will diminish the state`s pervasive influence, as illustrated
by its past and current subordination to industrial policy objectives.
Refarm/ng (he s(a(e sec(ar: The state-owned enterprises are not only the main
recipients of bank credit but also the main source of non-performing loans (NPL).
These enterprises therefore need to restructure their ownership and governance.
However, not all state companies are suitable for sale or infusion of outside capital.
Non-viable companies should be faced with a real threat of being wound up if they are
insolvent. This means allowing these enterprises to make staff redundant or reduce
their workforce to the numbers that are really necessary for business activity. While
concerns about potential job losses if firms go bankrupt are understandable, an even
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greater reliance on market bankruptcy in the short term is advisable in order to reduce
risks to the banking system and improve the competitive environment.
Prar/d/ng (he framewark cand/(/ans far dere/ap/ng (he pr/ra(e sec(ar: China`s
national champions¨ policy in strategic sectors¨ comes at a cost: an underdeveloped
competitive system. As a result, the way resources are allocated and industry is
structured is still to a considerable extent the outcome of policy rather than market
choices. Despite the WTO rules of national treatment¨ there is still no level playing
field for all economic operators in China, for domestic as well as foreign firms.
Substantial barriers to entry, exit and competition remain. With a general
antimonopoly law likely to be in place soon, China will have a fairly complete set of
competition laws. Law enforcement will then be the biggest challenge facing the
country. One major challenge will be to deal with potential conflicts between
industrial policy, FDI policy and competition policy, requiring a sufficiently
independent competition authority.
Ba//d/ng Ch/nese /nnara(/an capac/(v. China wants to transform the country into a
nation of innovation in 15 years. A new phase of development based on innovation
will obviate the danger of relying excessively on low cost to build and maintain
China`s competitive position in world markets. Moreover, new innovations in energy
and the environment will ease the pressure of growth on resources and the
environment. Even so, building an innovative society requires an integrated policy at
the highest level of the state. The first need is to develop the infrastructure at public
research institutes, universities and institutes of higher education. Secondly, and
perhaps more challenging for China, the private research infrastructure needs to be
improved and better geared to creating innovative products and processes that support
Chinese sustainable development. This implies putting the right framework conditions
in place for firms to have incentives to invest in R&D, which feeds back to reforms in
financial and product markets. Enforcement of intellectual property rights (IPR)
remains a major concern for both foreign and domestic innovating firms.
Labaar marke( refarms and demagraph/c cha//enges. China`s abundant labour
supply is the key to its successful transformation into the world`s manufacturing
powerhouse and the source of a large potential consumer base. At the same time, as
long as the supply of labour exceeds the demand for low-cost labour by today`s wide
margin, it constitutes a threat to sustainable socio-economic development. At the
moment China is barely able to stabilise the demand gap for unskilled labour at a level
that seems to be acceptable to society. Due to the restructuring process initiated and/or
speeded up by China`s WTO accession, millions of jobs will be shed by China`s state-
owned enterprises and its agricultural sector in the next years. Moreover, despite
China`s enormous pool of labour, there is a real shortage of skills in key areas, which
is impacting on staff retention and pay. Therefore, further reforms in the labour
market are needed to improve labour mobility geographically, across sectors and
skills. In the longer term, two major demographic challenges following on from the
one child¨ policy will come on top of this, namely a gender-imbalanced and ageing
population.
Reg/ana/ d/spar/(v. The policy of regional decentralisation has been an important
driver of economic development in China. However, regions which have been allowed
to transform themselves and industrialise faster have not been able to pull the other
regions with them sufficiently quickly, and the result has been to increase the regional
imbalances. The main barrier is to be found in self-enforcing effects that have boosted
the location advantages of those regions that were first to embark on the present
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growth path. These path dependencies may make government involvement necessary
in order to correct market failures¨, break up vicious cycles, and boost local
economic development up to a certain threshold level from where market forces will
suffice to attract funds and human resources.
Enr/ranmen(a/ cha//enges. The quality of the environment remains a serious cause
for concern in China. There has been progress in introducing pollution control. As a
result, emissions of polluting gases rose less rapidly than energy consumption, which
has itself risen less rapidly than GDP. However, the level of both water and air
pollution remains high. Air pollution is caused mainly by the use of coal with a high
sulphur content. New legislation has strengthened the fines for the emission of air and
water pollutants. But the major challenge is the effective monitoring and enforcement
of laws by local agencies. Another issue is the maldistribution of water relative to
requirements. To meet its environmental challenges, China is looking for and
investing in new technological developments.
Access (a na(ara/ resaarces. China is not particularly well endowed with national
resources to support its growth. To reduce its dependency on imports, it is devising a
growth strategy that builds on energy-saving technology and using energy more
efficiently. However, this will not be sufficient in the short to medium term. So state-
controlled companies are being urged to secure exploration and supply agreements
with countries producing oil, gas and other resources. For this, China is increasingly
turning to resource-rich developing countries. The Chinese government is courting
energy-rich states with bilateral trade agreements, aid, relieving debt, and helping
build infrastructure. The international reputation of some of these countries raises
major geopolitical concerns. Another important issue with geopolitical implications is
that of pipelines and access to sea lanes.
Imprar/ng (he /ega/ svs(em. With a legacy of 'rule of man` rather than 'rule of law`,
weak enforcement of improved legal and regulatory frameworks has been a recurrent
theme of China`s economic reforms. WTO accession commits China to improving
judicial enforcement of contracts and other business codes, including those governing
intellectual property and counterfeiting. However, there has been little fundamental
change in the judicial mechanisms for enforcement. Neither the independence of the
courts nor their jurisdiction are adequately established. Moreover, the legal obligations
of government entities to enforce or obey court decisions are not adequately
established, and court decisions are often ignored as a result. Enforcement is further
hampered by the limited experience of China`s courts of civil law proceedings, and
the limited training of judges and other judicial personnel. To improve enforcement,
the key objective is to strengthen the independence and clarify the jurisdiction of
courts, and to invest in a build-up of judicial know-how.
Pa//(/ca/ refarms. While the restructuring of the Chinese economy has been rapid,
China`s political reform process has been lagging behind. One big issue is the timing of
political reforms relative to economic reforms. Reforms have been carried out, e.g.
modernisation and professionalisation of the bureaucracy and the organisation of
elections at grassroots level. Moreover, faced with the daunting challenges of increasing
social unrest and rampant official corruption, the new Chinese leadership seems to be
making a stand for more transparency, greater accountability, and more distributive
justice. The government has also recognised the need for civil society to assist in
managing the social consequences of economic liberalisation. It has gradually transferred
some of its functions to civil society organisations, though it has also endorsed a number
of strict regulations to control their development and activities. These changes should not
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be underestimated. However, so far the political reform has essentially aimed at adapting
the existing political system to a new socio-economic environment by perfecting and
reinforcing one-party rule, not by challenging it. The Communist Party retains its grip on
power. The Chinese leadership argues that political stability is of the utmost importance
for the country, and indeed far-reaching political reform could have a destabilising effect
and jeopardise economic reform. However, it is questionable whether economic reform is
sustainable in the long term without any deeper political reform. If political opening at
the top is persevered with and combined with bottom-up pressure, we may well see the
emergence of a new Chinese political era conducive to genuine political reform. But
there is no certainty of this happening. Furthermore the new generation of leaders, i.e. the
fifth generation, will also be the most diverse elite generation in PRC history in terms of
views, values, education and professional background. What comes out of such a highly
contrasted new generation remains to be seen. It may lead to a more representative and
pluralistic political system or the outcome may be tensions and power struggles.
Overall, the biggest challenge for China is arguably that each of the individual challenges
cannot be tackled in isolation, but need to be dealt with in a systematic way, as failure to
advance in one area may jeopardise progress in other areas. So far China`s leadership
has shown a remarkable ability to steer development. The evidence so far gives little
reason to doubt China`s ability to progress towards its targets, bringing all its strengths
into play.
Part III: What challenges is Europe facing?
China`s rise is affecting Europe`s economy, as illustrated by the sizeable and growing
EU trade and FDI and by increasing competitive pressure in certain sectors. China`s
increasingly active stance in international affairs also has implications for EU foreign
policy.
The economic impact on Europe
China is the EU`s second largest external trade partner, behind the US. However, China
is primarily important for the EU as a source of imports. Accordingly, the EU is currently
China`s most important trading partner. These are not just low-cost imports. In line with
the general trend in Chinese exports, the data for the EU show a remarkable growth of
Chinese exports to the EU in high-technology sectors, illustrating that China is
increasingly moving into high-technology sectors, particularly IT. Overall, imports from
China have grown faster than exports to China, with growing deficits in China-EU trade
the inevitable result. Evidence suggests that the trade balance has worsened in nearly all
of the broad product groups.
Whereas a growing Chinese economy offers great trading potential and investment
opportunities for European business, and offers EU consumers a wider range of better
priced products, it may also present challenges for the European economy. Despite the
win-win situation in the long run, in the short term the EU needs to adjust and
restructure, particularly in those areas where the EU is losing ground and China is
building a comparative advantage.
A comparison of China`s and the EU`s comparative advantages helps to determine how
EU firms will be affected by China`s rise. To some extent there is a degree of
complementarity. In most areas where China is losing competitiveness the EU gains -e.g.
chemicals and rubber and plastics - or is holding its ground, as in electrical engineering.
In areas where China has gained competitiveness, the performance of the EU is more
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mixed. In mechanical engineering and electronic engineering the EU-15`s
competitiveness has declined. In computers - where China`s improvement has been most
marked - the EU-15 has been only modestly affected. However, this still means being
stuck in a low and disadvantaged position. For European firms with no strong
comparative advantage in IT sectors, the only opportunity to export to China is in those
areas where they command a sustainable technology leadership. While the improvement
in China`s competitiveness in cars is still modest, the trend in China`s competitiveness in
cars is most likely to be upwards, given that cars have been selected as a strategic sector
by the Chinese government. Sometimes, Europe retains an advantage in surprising areas.
This is the case for food & beverages and textiles & clothing, where the EU-15 has been
gaining competitiveness. The improved situation for European producers in textiles &
clothing reflects the strength of high-end products and luxury brands.
The challenge from China is particularly relevant for the new Member States, which are
losing ground in textiles, clothing and leather products, and food & beverages. These are
sectors where the new Member States used to perform strongly, but where they currently
face stiff competition. In all these sectors China is improving its trade competitiveness.
A considerable share of the EU`s trade with China is conducted with foreign firms
located in China. Nevertheless, Europe is not one of the most important investors in
China. In quantitative terms European FDI engagement is moderate. It is only a very
small share of total European FDI outflows that finds their way to China. There is
accordingly scope for Europe to develop its investment relationship with China further.
The moderate relative share of the West European economies, however, cannot hide the
fact that the absolute volumes of China-bound FDI flows have multiplied in recent years.
In the past, European FDI to China has mostly been resource seeking¨, and accordingly
European investment projects in China are highly concentrated in manufacturing
activities. European capital has been attracted by the low cost of production in China and
less by the actual size and potential of the Chinese market. Consequently a considerable
share of foreign production has been exported, and has not been sold on the Chinese
market
The EU's current China policy
The EU has since 1998 been pursuing five long-term aims in its China policy: (i)
engaging China more by stepping up the political dialogue, (ii) supporting China`s
transition to an open society based on the rule of law and respect for human rights, (iii)
integrating China further into the world economy, (iv) making better use of existing
European resources, and (v) raising the EU`s profile in China. A Communication
published in 2003 provided an updated list of concrete action points derived from these
aims. They form the basis for the European Commission`s institutional set-up for
ongoing dialogue with the Chinese authorities, ranging from an annual Summit at the
most senior policy level, covering all areas, to ongoing detailed discussions at service
level in specific policy areas.
In recent years EU-China relations have developed into what is considered to be a
long-term strategic partnership¨ going beyond trade and economic issues and
encompassing regular high-level political contacts, and exchanges on a broad range of
sectoral issues. However, the EU-China relationship is often perceived as being restricted
to joint declarations on global multilateralism, and promoting democracy, peace and
stability, and it seems that the political dialogue has not actually caught up with the
reality of intense trade relationships. Moreover, Beijing is viewed as having grasped
xxi
01_2006_4142_txt_EN.indd 21 12-07-2007 10:43:07
perfectly well the benefits it can derive from the internal competition between Member
States.
xxii
01_2006_4142_txt_EN.indd 22 12-07-2007 10:43:07
PART I: WHERE DOES CHINA STAND TODAY?
China has undergone a remarkable transformation over the past three decades. Since the
decision to embark on a comprehensive programme of economic reform. starting in 1978
with its ¨open door' policy. the Chinese economy has grown by 9%per year on average.
and a large part is now in private hands. In the course of the last decade. China has
become a major player in the world economy. capturing an increasing share of world
trade and investment flows. Compared to these huge economic transformations. the
changes to China's political power structures have been much more modest. with China
remaining a one-party communist state. However. while the Party continues to reign
supreme. economic developments are demanding changes to the underpinning
institutional framework. Recognising this reality. China's leaders are in a constant
process of upgrading the institutional framework. China's increasing economic weight
has also brought more attention to the role China plays in the East Asia region. in the
world economy and in the international system in general. China's foreign policy is
currently evolving. seeking to exercise influence while reassuring its partners about its
intentions.
The first chapter of this part presents the contours of China's political system. Chapter 2
reviews China's sources of growth during the last two decades. The third chapter
assesses the role China currently plays in the world economy. Finally. chapter 4
analyses how China's international policy stance has evolved as a result of its economic
development.
01_2006_4142_txt_EN.indd 1 12-07-2007 10:43:07
1. THE POLITICAL SYSTEM
The People`s Republic of China (PRC)
1
is an autocratic one-party state, dominated by the
Chinese Communist Party (CCP). The Chinese leadership stresses how China`s unique
conditions make it unprepared to adopt a Western-style democracy. That does not mean
that political reforms are rejected per se. However, they must be pursued in an orderly
way that takes into account Chinese characteristics and does not jeopardise the political
and social stability of the country.
The Chinese leadership understands many of the problems it faces and is taking measures
to address some of them. However there is no real significant commitment to genuine
democratic change, as yet. Nevertheless, the regime`s resilience is remarkable. The CCP
shows a great capacity to adapt to an evolving society and to become more accountable
and somehow less authoritarian while maintaining its grip on power. The current status
of China`s political system is discussed in this chapter; the pace of political reforms and
remaining challenges are discussed in part II of the report.
1.1. ~Socialist democracy¨ with Chinese characteristics
On 19 October 2005 the State Council Information Office issued for the first time ever a
White Paper entitled Building of Political Democracy in China¨. This publication can
be viewed as China`s response to Western criticisms over the pace of political reforms in
the country. The document presents the argument for a Chinese style of socialist
democracy¨ - a choice suited to China`s conditions¨ - and for the continued dominance
of the Chinese Communist Party (CCP) over the country`s political life. The White Paper
gives a detailed account of the foundation, development and principles of China`s
political democracy. Modern China should indeed always be considered against the
backdrop of its past. It is impossible to detach today`s China from its history of pride
and humiliation¨.
Within Chinese society there is a widespread sense of pride in China`s culture, ancient
heritage and contributions to civilisation. There is often also a sense of injustice and
victimisation. China`s Communist leaders have always embraced the nationalist mission
of ending what is described as China`s national humiliation¨ and restoring China to its
historical position and international eminence. In those nationalistic terms, China is
perceived as more than a nation-state; it is one of the great world civilisations unified by
a literary culture and by philosophical and religious traditions whose origins lie deep in
antiquity.¨
2
China`s history is characterised by a long period of feudalism, followed in
the nineteenth century by a period of semi-feudal and semi-colonial society¨ under the
Western imperialist powers.¨
The White Paper notes that the Bourgeois Revolution¨ of 1911 brought an end to that
period of deep humiliation. However the parliamentary and multi-party system that was
then established in imitation of the model of Western democracy did not fulfil the
1
Throughout the report we use the labels China¨ to refer to People`s Republic of China¨, Hong
Kong¨ to refer to People`s Republic of China - Hong Kong Special Administrative Region¨,
Macau¨ to refer to People`s Republic of China - Macau Special Administrative Region¨, and
Taiwan¨ to refer to Taiwan Province of China¨. All statistical data presented are based on customs
territories. Data for China are therefore restricted to Mainland China¨. Statistical data for Hong Kong,
Macau and Taiwan are provided separately.
2
John Friedman, China's Urban Transition, University of Minnesota, 2005
2
01_2006_4142_txt_EN.indd 2 12-07-2007 10:43:07
fervent desire of the Chinese people for independence and democracy¨. Drawing the
lessons from the past, the new democracy that has now developed is characterised by
thorough opposition to imperialism, feudalism, and bureaucratic capitalism¨.
Box 1-1: A snapshot of China`s recent history
Given the length of its history and the richness of its culture, a view of China`s history is important to
understand its present and its future. Notwithstanding various ups and downs, imperial China spanned a
period of over 2000 years.
3
In 1820, China`s economy was the largest in the world, accounting for some
30% of world GDP. However, the next 150 years mark China`s decline in the world rankings. The
combination of anarchy, competing war lords, foreign suppression (e.g. the Opium War, Boxer Rebellion),
civil war and the Sino-Japanese conflict saw China`s share of the global economy slip to below 5% in
1950. What follows is a snapshot of major events in China`s 20
th
century development up to 1992, which
marks the Take Off of China.
1912: Qing`s dynasty rule ends with the founding of the Republic of China; creation of the Nationalist
Party or Kuomintang (KMT)
1921: China`s Communist Party (CCP) created in Shanghai, quickly develops a rural power base.
Simultaneously, it develops its own military capability in the form of the Red Army, later turned into the
People`s Liberation Army (PLA).
1935: the CCP undertakes the Long March to Yanan, an event which gave Mao Zedong the upper hand in
the CCP.
1937: Sino-Japanese war starts. Initially CCP and the KMT form a united front, but the war weakens the
KMT.
1947: Final phase of the civil war, with the de facto exile of Chiang Kai-shek and the KMT to Taiwan and
with the CCP, headed by Mao Zedong, taking power and proclaiming the People`s Republic of China
(PRC).
1949: end of the civil war, with KMT driven from the mainland and taking refuge on Taiwan.
1958: Mao Zedong launches the Great Leap Forward, i.e. the collectivisation of agriculture, which led to
the famine of 1959-1962 in which an estimated 20 million people perish.
1966: Mao Zedong and the Gang of Four¨ launch the Cultural Revolution. The aim is to block the rise of
the new bourgeoisie¨ in the party ranks. This produces violent and widespread upheaval, forcing Mao to
order the PLA to step in to restore order.
1976: death of Mao Zedong, Gang of Four arrested and Hua Guofeng becomes Premier. In reality, Deng
Xiaoping seizes power.
1978: Deng Xiaoping starts the reform era.
1980: Zhao Ziyang, protégé of Deng, appointed Premier and becomes driving force of reforms, e.g. via the
creation of special economic zones.
1982: 12
th
party congress agrees on building socialism with Chinese characteristics¨.
1987: 13
th
party congress concludes that China at initial stage of socialism¨ and primary task is
eliminating poverty. But, increasing unease within CCP at impact of economic liberalisation on party
authority.
1988: Zhao ousted following the economy overheating and discontent with the changes brought about by
economic liberalisation. Replaced by a conservative, Li Peng.
3
viz. the Zhou, Han, Jin, Sui, Tang, Song, Ming and Qing(Manchu) Dynasties.
3
01_2006_4142_txt_EN.indd 3 12-07-2007 10:43:07
1989: Li Peng`s reining-in of reforms and austerity programmes lead to student protests on Tiananmen
Square. Imposition of martial law. The PLA crushes the student uprising. Jiang Zemin becomes party
chair.
1992: Dissatisfied by slow progress of reforms, Deng Xiaoping returns from official retirement and
undertakes tour of Southern China promoting rapid reform.
Source: Lehman Brothers (2002).
1.2. Administrative division
China is at present divided into 22 provinces, five so-called autonomous regions and four
municipalities directly under the Central Government. In practice provincial officials
have a large amount of discretion to implement policy goals which are set by the central
government and in which provinces and localities actively compete with each other in
order to advance economically.
The autonomous regions are province-level divisions with a designated ethnic minority,
and are guaranteed more rights under the Constitution. For example, they have a
chairman (where regular provinces have governors), who must be of the ethnic group as
specified by the autonomous region. The overwhelming majority of the Chinese people
(91.6%) are Han. The non-Han population includes 55 ethnic minorities of which the
major groups are the Zhuang, Hui, Uighur, Mongolian, and Tibetan.
Figure 1-1: China`s provinces
Source: http://www.chinapage.com/map/map.html
China also has two Special Administrative Regions (SAR), Hong Kong and Macau,
which enjoy considerable autonomy - separate governments, legal systems and quasi-
constitutions (Basic Laws) - but the PRC is responsible for their foreign affairs and
defence. The government of the PRC considers Taiwan, which is controlled by the
Republic of China, as its 23rd province.
4
01_2006_4142_txt_EN.indd 4 12-07-2007 10:43:07
Table 1-1: Administrative division
Provinces (22) Anhui
Fujian
Gansu
Guangdong
Guizhou
Hainan
Hebei
Heilongjiang
Henan
Hubei
Hunan
Jiangsu
Jiangxi
Jilin
Liaonong
Qinghai
Shaanxi
Shandong
Shanxi
Sichuna
Yunnan
Zhejiang
Autonomous regions (5) Guangxi (Zhuang)
Inner Mongolia (Mongols)
Ningxia (Hui, Chinese speaking
Muslims)
Xinjiang (Uighurs, Turkish
speaking Muslims)
Tibet
Large municipaIities (4) Beijing
Chongqing
Shanghai
Tianjin
SpeciaI Administrative Regions (2) Hong Kong Macau
CIaimed by the PRC Taiwan
1.3. Main political institutions
The CCP and the government structures run in parallel, extending from the centre
(Beijing) down to local levels. This territorial organisation is based on a number of
administrative divisions, with both a CCP committee and a people's government¨ in
charge of each. These bureaucracies are assisted by various mass movements¨ - trade
unions, a youth league, women's associations, writers' and other professional associations
- that include key sectors of the population.
According to the Constitution, the National People`s Congress (NPC) is the highest
organ of state power. However, this is in practice not the case. Real decision-making
authority in China is held by the CCP and the State Council, which is led by the Premier.
No policy can be made in a ministry without the approval of the Party. However, a
remarkable change in the policymaking process was initiated under Jiang Zemin.
The Chinese leadership - aware of the need to get a better understanding of the world
and to work out increasingly sophisticated positions, in particular in international forums
and institutions - has developed a more consultative and rational policymaking process.
It is increasingly relying on intellectuals and experts for policy advice on a broad range
of issues
4
.
4
For example on foreign affairs the Chinese leadership relies on the expertise and advice of the China
Institute of International Studies, the China Institute of Contemporary International Relations (CICIR),
the Chinese Academy of Social Sciences (CASS) or the Fudan University`s Centre for American
Studies. The People`s Liberation Army (PLA) relies among other institutes on the Foundation for
International and Strategic Studies, an entrepreneurial group of military intelligence officers, which
has done studies for the top leadership on the development of western China; cross-strait relations,
national security decision-making, and crisis management.
5
01_2006_4142_txt_EN.indd 5 12-07-2007 10:43:08
1.3.1. The Chinese Communist Party (CCP)
With a membership of 68 million, the CCP is the largest political party in the world.
Since the launch of economic reforms, the Party has however lost its original ideological
appeal. New party members are said to be more likely to join because of economic
benefits from membership.
The National Party Congress of more than 2 000 delegates is in theory the highest body
of the CCP. It meets every five years to elect a Central Committee of some 200 members.
The Central Committee meets once a year and elects the Political Bureau (Politburo) and
its Standing Committee. The 22-member Politburo, and notably the 9-member Standing
Committee, is in practice the party`s most powerful body and hence the supreme
policymaking council in China. It sets policy and controls all administrative, legal and
executive appointments.
6
01_2006_4142_txt_EN.indd 6 12-07-2007 10:43:08
Figure 1-2: China`s State Organs
Formal structure of central government Power structure of central government
Source: Adapted from Stephanie Hemelryk Donald and Robert Benewick, The State of China Atlas, University of California Press, 2005
NationaI PeopIe's Congress
NPC Standing Committee
State
Council
Central
Military
Commission
Supreme
People's
Court
Supreme
People's
Procuratorate
PRC Presidency
NationaI PeopIe's Congress
NPC Standing Committee
State
Council
Central
Military
Commission
Supreme
People's
Court
Supreme
People's
Procuratorate
PRC Presidency
LegisIature
National People's
Congress (NPC) &
Standing Committee
Judiciary
Supreme People's
Court
Supreme People's
Procuratorate
MiIitary
Central Military
Commission
(state & party)
Executive
President, secretary
general of CCP
State Council
LegisIature
National People's
Congress (NPC) &
Standing Committee
Judiciary
Supreme People's
Court
Supreme People's
Procuratorate
MiIitary
Central Military
Commission
(state & party)
Executive
President, secretary
general of CCP
State Council
7
0
1
_
2
0
0
6
_
4
1
4
2
_
t
x
t
_
E
N
.
i
n
d
d



7
1
2
-
0
7
-
2
0
0
7



1
0
:
4
3
:
0
8
Box 1-2: Members of the Politburo`s Standing Committee
In 2002 the 16th Party Congress saw the succession to power of the Fourth Generation of Party leaders.
Jiang Zemin stepped down and Hu Jintao was elected General Secretary of the Party.
5
It also saw the
opening of the Party to capitalists and private entrepreneurs in accordance with Jiang Zemin`s Three
Represents¨ theory that was then included in the Constitution. The theory refers to the CCP mission to
represent three essential concerns 1) the development of China`s advanced productive forces, 2) the
development of China`s advanced culture, and 3) the fundamental interests of the overwhelming majority
of the people in China.
Hu Jintao
General Secretary of Communist Party 2002-
President of the PRC 2003-
Chairman of the Central Military Commission of the PRC 2004-
Zeng Qinghong
Vice-President of the PRC 2003 -
Secretary of Central secretariat of CCP 1997 -
President of Central Party School 2002 -
Wen Jiabao
Premier of the State Council 2003 -
Wu Bangguo
Chair of Standing Committee of National People`s Congress 2003-
Jia Qinglin
Chairman of Chinese People`s Political Consultative Conference 2003 -
Huang Ju
Vice-Premier of the State Council 2003-
Wu Guanzheng
Secretary of Central Discipline Inspection Commission 2002-
Li Changchun
Standing Committee member in charge of the ideological front 2002-
Luo Gan
Secretary of Central Political and Legal Commission 2002-
Note. The Politburo`s Standing Committee was expanded from 7 members to 9 in 2002. Hu Jintao was the only remaining member of
the previous Standing Committee. Of the 8 new members, 6 are Jiang Zemin`s protégés linked to the so-called Shanghai clique¨:
Zeng Qinghong, Wu Bangguo, Jian Qinglin, Huang Ju, Wu Guansheng, and Li Changchun.
5
Hu Jintao`s leadership marks the first smooth power transition in the history of the PRC. It is a recent
transition that has developed progressively, building on the demise of the concept of paramount leader
following the death of Deng Xiaoping. Hu Jintao only became Chairman of the Party in 2002,
President in 2003, and Chairman of the State Central Military Committee in 2004. For most analysts
Hu Jintao`s hold on power will be tested in the coming months when the preparations for the 2007 17
th
CCP Congress will start to be unveiled. Then a number of decisions would have to be followed closely
to assess his real power and intentions, that include appointments at provincial and national levels,
appointments to the Central Committee, and composition of the Committee in charge of drafting the
political report to be delivered by Hu at the Congress.
8
01_2006_4142_txt_EN.indd 8 12-07-2007 10:43:08
The CCP also has a Central Discipline Inspection Commission that is in charge of
detecting and punishing abuses of office by Party members, and a Central Military
Commission by which it retains control over China's armed forces. There are party
organisations in cities, towns, villages, neighbourhoods, major workplaces, and so on.
Box 1-3: The eight democratic* parties
The White Paper refers to a system of multi-party cooperation and political consultation under the
leadership of the CCP, and with the CCP holding power and participating fully in state affairs.
Actually the eight small democratic parties are loyal to the CCP and do not provide any political opposition
whatsoever. They are members of the Chinese People`s Political Consultative Congress (CPPCC), a
powerless advisory body which comprises over 2 000 delegates including scholars, educators, intellectuals,
and key representatives of women`s organisations, religious bodies and minority nationality groups. The
CPPCC meets once a year in conjunction with the National People`s Congress (NPC).
The China Zhi Gong Dang (or China Party for Public Interest), founded in 1925, has more than 15 000
members, essentially Chinese who have returned from overseas. The party has many foreign connections.
The Chinese Peasants and Workers Democratic Party, founded in 1930, has some 65 000 members,
most of whom work in public health, culture, education, science and technology.
The China Democratic League, founded in 1941, has some 144 000 members, most of them being
intellectuals.
The China National Democratic Construction Association, founded in 1945. Party members are mainly
entrepreneurs from both private and state sectors. The chairman of the party Cheng Siwei is Vice-chairman
of the Standing Committee of the National People's Congress.
The China Association for Promoting Democracy, founded in 1945.
The Jiusan Society, founded in 1945. The party`s name commemorates the victory on 3 September 1945
in the Sino-Japanese War and the international antifascist war. It has a membership of over 68 000, mostly
intellectuals.
The Taiwan Democratic Self-Government League, founded in 1947, has a membership of some 1 600
people.
The Revolutionary Committee of the Chinese Kuomintang, founded in 1948 by leftists who broke off
from the main Kuomintang during the Chinese Civil War. Song Qingling. The party claims to be the true
heir of Sun Yat-sen's legacy. It has over 53 000 members.
¯ ¨Since most of these political parties were founded during the War of Resistance Against Japanese Aggression (1937-1945) and
the War of Liberation (1946-1949) in the pursuit of national liberation and democracy of the people. they were given the joint name
of `democratic parties'' (from the White paper on Political democracy).
1.3.2. The legislative body. the National People's Congress (NPC)
China`s Constitution states that the NPC is the highest organ of state power. The White
Paper on Political Democracy emphasises that it represents the common will and
fundamental interests of the people. In fact the NPC is heavily influenced by the CCP,
which retains a large measure of control over the process of delegate selections.
However, in recent years the NPC has begun to move away from its basically symbolic
role as a rubber-stamp institution to become a more professional legislature.
The NPC and its permanent body the Standing Committee exercise the legislative power
of the State. The NPC passes laws and treaties, elects the executive and approves the
Constitution. It is currently composed of 2 937 delegates elected by the provinces,
9
01_2006_4142_txt_EN.indd 9 12-07-2007 10:43:08
autonomous regions and municipalities and by the armed forces for a five-year term The
NPC meets once a year in plenary session, taking stock of government action. Between
these plenary sessions, power is exercised by the Standing Committee of the NPC, which
comprises 153 members.
Box 1-4: China`s eleventh five-year Programme
6
(2006-2010)
The 2006 Plenary Session of the 10th NPC met in Beijing from March 5 to March 14. Formal issues listed
for discussion included the so-called Three Nongs¨ problem - agriculture (nongye), peasants (nongmin),
and rural communities (nongcun) - and the need to crack down on corruption. Premier Wen Jiabao made
the annual Government Report to the Congress outlining government` s work in 2005 and the way ahead
with a strong emphasis on helping the poor and closing the wealth gap.
The NPC overwhelmingly endorsed Premier Wen Jiabao's government work report (98.86% in favour) and
the Party`s suggestions for the eleventh five-year Programme (97% in favour).The final validation of the
government's action plan signifies China's major shift in economic policies from urban development and
heavy investment in billion-dollar projects, to increasing rural development and investment in scientific
technology for sustainable development,¨ said Li Chong'an, an NPC deputy and vice-chairman of the NPC
Law Committee.
The Programme signals a notable shift from getting rich first¨ to common prosperity¨ and from growth
rate¨ to sustainable development¨. It reflects the Chinese leaders` concerns that a fragile social cohesion
may undermine economic growth.
It is firmly inscribed both in the theory of scientific development¨ and in the objective of the five
balances¨ enunciated by the Hu-Wen administration. Scientific development¨ means, as Premier Wen put
it, ensuring that GDP expansion would go hand-in-hand with market improvement in employment, social
security, poverty reduction, education, medical care and environmental protection.¨ The five balances¨
objective points to the need to achieve a more balanced development in five main interconnected areas:
across geographical regions;
between urban and rural areas;
between economic growth and social improvement;
between the needs of the people and the sustainability of the environment, and
between the promotion of foreign trade and the need to stimulate China`s internal market.
The 11th five-year Programme gives only two quantified objectives: (i) GDP per capita in 2010 should be
double that of 2000, and (ii) energy consumption per unit in 2010 should be about 20% lower than it was at
the end of the 10
th
five-year Plan in 2005. The objective is for China to create an economy that economises
on resources and that develops along the lines of a 5 R¨ policy: Rethink, Reduce, Re-use, Recycle and
Repair.
7
1.3.3. The Presidency
Formally the President is elected by the NPC; in practice, this election falls into the
category of 'single-candidate` elections. According to the Constitution, the President
cannot serve for more than two five-year terms. The President is the Head of State. To
date, six men have held the office of the President of the PRC: Mao Zedong, Liu Shaoqi,
Li Xiannian, Yang Shangkun, Jiang Zemin, and the current president, Hu Jintao, who
was elected on 15 March, 2003. One notable absentee from this list is Deng Xiaoping,
who in spite of being paramount leader shunned the highest ranks of either party or state.
6
The 11
th
Five Year Plan has been renamed Programme¨ to emphasise that qualitative guidelines are
progressively replacing quantitative hard planning¨.
7
Barry Naughton, The New Common Economic Program. China's Eleventh Five-Year Plan and What
It Means, China Leadership Monitor, Issue 16, Fall 2005
10
01_2006_4142_txt_EN.indd 10 12-07-2007 10:43:09
1.3.4. The executive body. the State Council
The State Council - the Central People's Government - is the highest state administrative
body. It is responsible to the NPC and its Standing Committee, and reports to them on its
work. In practice the NPC's actual authority over the State Council is rather limited.
The State Council is composed of the Premier, Vice-Premiers, State Councillors,
Ministers in charge of ministries and commissions, and the Secretary General. The
President nominates the Prime Minister, who then nominates his government. They are
all appointed by the President upon the approval of the NPC. The full Council meets
once a month, but the more influential Standing Committee meets twice a week. The
Standing Committee accordingly exercises day-to-day decision-making authority, and its
decisions de facto have the force of law.
The State Council is the functional centre of state power and clearing-house for
government initiatives at all levels. With the government's emphasis on economic
modernisation, the State Council clearly acquired additional importance and influence.
The State Council`s most important roles are to draft and manage the national economic
plan and the state budget. It also has the power to formulate administrative measures,
enact administrative regulations, and promulgate decisions and orders within its
functions and powers.
The administrative rules and regulations issued by the State Council rank immediately
below the laws enacted by the NPC. However they affect their implementation. By the
year 2000, about 250 laws had been promulgated in China, while the State Council had
issued over 800 administrative regulations.
8
Such a situation creates some confusion on
the ground, including contradictions between laws and regulations.
1.3.5. The leading small groups (lingdao xiaozu)
The leading small groups (LSG) do not appear on organisational papers. They are inter-
agency coordinating bodies on key policy issues (e.g. economic affairs, foreign affairs,
national security, Taiwan affairs). They have become increasingly important in the PRC
since the 1990s, especially in the field of foreign policy. They are sometimes ad hoc and
sometimes formal and permanent. They form a bridge between the Politburo and State
ministries and bureaucracies. They are composed of members of the CCP and are chaired
by Politburo members. On foreign policy, for instance, the decision-making body is the
Foreign Affairs leading small group, which is currently chaired by Hu Jintao.
1.3.6. The Central Military Commission
Command and control of China`s armed forces, including the People's Liberation Army
(PLA), People's Police Force and Civilian Force, is exercised by the CCP's Central
Military Commission. Under the 1982 Constitution, the highest military body in the
Chinese Government is the State Central Military Commission. In fact, the leadership of
both bodies is identical. So the two commissions are practically one body with two
identities, reporting to the Party`s Central Committee and the NPC respectively. Hu
Jintao was elected chairman of the Party Central Military Commission in 2004 and
chairman of the State Central Military Commission in 2005.
8
Laura Paler, China's Legislation Law and the Making of a More Orderly and Representative
Legislative System, The China Quarterly, 2005
11
01_2006_4142_txt_EN.indd 11 12-07-2007 10:43:09
1.3.7. The Judiciary
China has a four-tier court system. The Supreme People´s Court sits in Beijing. Higher
People's Courts sit in the provinces, autonomous regions and municipalities. Intermediate
People's Courts sit at the prefecture level and also in parts of provinces, autonomous
regions, and municipalities. There are also basic People's Courts in counties, towns, and
municipal districts. Special courts handle matters affecting military, railroad
transportation, water transportation, and forestry. The court system is paralleled by a
hierarchy of prosecuting authorities called People's Procuratorates; at the apex of this
structure stands the Supreme People's Procuratorate.
The reform of China`s legal system has been one of the most important aspects of
political system evolution during the process of economic modernisation. These reforms
will be discussed in more detail in part II.
1.4. The People`s Liberation Army (PLA)
The history of the PLA is officially traced to the NanChang uprising of 1 August 1927
(the first major Kuomintang-Communist engagement of the Chinese Civil War), which is
celebrated annually as PLA Day. With its 2.25 million members (3.25 million if active
paramilitary personnel are included) the PLA is one of the world`s largest military forces
in terms of sheer number of troops. It is formally under the command of the Central
Military Commission.
The PLA consists of five branches: (i) the Ground Force (including the Army Special
Operation Forces); (ii) the Navy (including the Marine Corps and the Naval Air Force);
(iii) the Air Force (including the Airborne Force); (iv) the Second Artillery Corps
(strategic missile force), and (v) the People`s Armed Police (internal security troops
nominally and border defence guards subordinate to the Ministry of Public Security).
Troops around the country are stationed in seven military regions and more than 20
military districts.
China is in the process of modernising its armed forces and has embarked on a two-
phased plan to scale down into a smaller, higher-quality force and to focus on high
technology application. According to a senior Chinese researcher, Huang Haiyuang
9
the
PLA`s modernisation is aimed at seven technological priorities: information operation
and warfare; air and missile technology; precision guided munitions; defensive weapon
technology; unmanned aerial vehicle technology; and naval carriers. This modernisation
process reflects the wish to be in a position to successfully wage local or limited wars
under high-tech conditions (i.e. basically to keep the US away from Taiwan, and protect
access to natural resources and notably communications sea lanes).
China`s defence spending has over the last fifteen years enjoyed double-digit growth.
According to the official Chinese state budget the country allocated about $30 billion for
military spending in 2005. Most analysts estimate that China is hiding some of its
defence spending (the official figures do not include new arms purchases and weapons
research and development).
9
Quoted by Charles F. Hawkins, The People's Liberation Army Looks to the Future, Defence Technical
Information Centre (DTIC° summer 2000). http://www.dtic.mil/doctrine/jel/jfq_pubs/0525b.pdf
12
01_2006_4142_txt_EN.indd 12 12-07-2007 10:43:09
Table 1-2: China`s official defence budget
Year Yuan bn USDbn Percentage
increase
China's officiaI defence budget
(USDbn)
1991 32.5 3.9 -
1992 37.0 4.5 13.8%
1993 42.7 5.1 15.2%
1994 55.0 6.6 28.8%
1995 63.0 7.6 14.5%
1999 107.7 13.0 15.2%
2000 121.3 14.6 12.6%
2001 141.0 17.0 17.7%
2002 166.0 20.0 17.6%
2003 185.3 22.4 9.6%
2004 206.5 25.0 11.6%
2005 247.7 29.9 12.6%
0
5
10
15
20
25
30
35
1991 1993 1995 2000 2002 2004
Source: http://www.globalsecurity.org/military/world/china/budget.htm
China`s real defence spending is certainly higher than the publicly disclosed figures but
probably not the three times higher estimated by the Pentagon.
10
A number of experts
believe that China`s real level of military spending is about $40 billion to $55 billion,
which is actually rather modest for a nation of 1.3 billion people. While understanding
China`s desire to preserve some secrecy about its military programmes, many observers
would welcome a move towards more transparency.
Box 1-5: China`s Defence White Paper - Command of the sea, command of the air and
strategic counter-strikes
China`s fourth Defence White Paper, China's National Defence in 2004. shows that China`s views of the
security environment have been consistent over the last five decades, i.e. the emergence of a multipolar
world along with an inevitable relative decline in the United States power (see also Chapter 4). The
multipolar world will be a turbulent one characterised not by a world-wide war but a number of local wars
whose main cause will be struggles over natural resources.
11
Chen Qimao, former President of the
Shanghai Institute for International Studies, considers that the world is still in a post Cold-War transitional
period marked by the basic formation of the new multipolar structure¨, a time where the old structure has
already ended but the new structure has not yet been formed. That is the time of the emergence of one
superpower and many strong ones or the so-called 1-2-3-5 layers:
One superpower, the United States;
Two military powers, the United States and Russia;
Three economic powers, the United States, Japan and Europe; and
Five political powers, the United States, Japan, Russia, Europe and China.¨
Moreover studies from the Centre for Foreign Policy at the China Institute of Contemporary International
Relations (CICIR) and the Chinese Academy of Social Sciences (CASS) warn about the dangerous decade
to come between 2020 and 2030 when the United States leadership will finally realise that China`s power
is about to surpass that of the United States.
12

10
The US Department of Defence estimates China`s defence budget for 2005 at about $90bn. Even if we
assume that the US figure is correct the PLA budget would still be a fraction of US defence spending
(around $480bn.)
11
Michael Pillsburg, China Debates The Future Security Environment, National Defence University
Press, January 2000
12
Ibid.
13
01_2006_4142_txt_EN.indd 13 12-07-2007 10:43:09
The 2004 White Paper assesses that the trends towards world multipolarisation and economic
globalisation are deepening amid twists and turns. (.) New and profound readjustments have taken place
in the relations among the world's major countries. While cooperating with and seeking support from each
other, they are checking on and competing with one another as well. With their overall strength continuing
to rise, the developing countries have become important players in promoting a multipolar world and
democratised international relations.¨
The White Paper expresses concerns about the world`s major countries which are making readjustments
in their security and military strategies¨ and more specifically about the increased complicated factors in
the Asia-Pacific region¨: the United States is realigning and reinforcing its military presence in this region
by buttressing military alliances and accelerating deployment of missile defence systems¨; and Japan is
adjusting its military and security policies and developing the missile defence system for future
deployment.¨ Furthermore it is the sacred responsibility of the Chinese armed forces to stop the "Taiwan
independence" forces from splitting the country.¨
The Paper states that a fair and rational new international political and economic order is yet to be
established¨. It acknowledges that China`s national security environment in this pluralistic, diversified
and interdependent world has on the whole improved¨, however new challenges keep cropping up.¨
Therefore, the military factor plays a greater role in international configuration and national security¨. In
this context the White Paper calls for the People`s Liberation Army (PLA) to craft military forces capable
of winning both command of the sea and command of the air, and conducting strategic counter-strikes.¨
13
Today China`s world views seem consistent with ancient Chinese tales of dynastic foundations which
highlight the ability of the weak to defeat the strong. The emphasis is put on the artfulness of the conquest
including resolve, patience, sensitivity to disguise, knack for devising ruses and ability to recognize and
exploit opportunities.¨
14
13
http://english.chinamail.com.cn
14
Jacqueline A. Newmyer. China's Air Power Puzzle, Policy Review, June-July 2003
14
01_2006_4142_txt_EN.indd 14 12-07-2007 10:43:10
2. THE SOURCES OF ECONOMIC GROWTH
China`s economic growth performance over the last decade has been impressive,
outpacing most other OECD countries, as well as other Asian Tigers. Furthermore,
unlike many other emerging market economies, China has not experienced any sharp
disruptions to growth during this period.
As a consequence of this impressive
sustained growth rate, the Chinese economy
in 2004 already accounted for 13% of world
GDP, substantially closing its gap with the
developed world. Nevertheless, as the
following table clearly shows, despite these
impressive growth rates, the gap in terms of
GDP per head remains huge, due to the
sheer size of the Chinese population that
needs to be brought out of poverty
15
.
With Chinese GDP per head being only one
fifth of the EU-25`s, the Chinese economy
needs to continue to produce substantial
economic growth in future if it wants to
reach its target of a harmonious¨ or well-
off¨ society. China`s 11
th
five-year programme (2006-2010) has a stated goal of
increasing GDP four-fold between 2000 and 2020, which would imply an annual growth
rate of just over 7%. Pursuing a gradually rising and sustainable growth path, China
would like to have advanced, by 2050, as a democratic socialist country on a par with
the middle ring of advanced nations¨.
Table 2-1: China`s economy compared
China EU-25 US
Nominal GDP, USD bn 1,910 13,459 12,452
GDP at PPP, USD bn 7,334 12,329 11,605
Share of world GDP (PPP, %) 13% 21% 21%
Population, m. 1,297 455 294
GDP per head, at PPP, USD 5,657 27,079 39,540
Source: World Bank Indicator, IMF. All figures are 2004 estimates.
To gaugue the feasibility of China`s growth targets, we need to better understand the
drivers of current Chinese growth. In comparison to other developing economies, China
is endowed with favourable preconditions for economic development and growth: a large
supply of labour, an entrepreneurial drive, a high savings rate, and a large (potential)
domestic market. However, as other developing countries and China have experienced in
the past, resources alone are not sufficient to create economic growth. What is important
is how these resources are employed. The institutional framework is particularly critical,

15
In 2002, China had 180 million people living on $1 a day, down from 334 million in 1993 and 634
million in 1981. As a share of the total population this is 14% in 2002 and 28% in 1993. (Source:
World Bank Indicators)
Average Annual % Change in
Real GDP Growth (1994-2004)
China 10%
EU-15 2.8%
NMS-8 4.4%
US 3.6%
Japan 1.6%
Tigers 4.4%
India 6.9%
Note: China excluding Hong Kong; Tigers are Hong Kong,
South Korea, Singapore, Indonesia, Malaysia, Philippines
and Thailand.
Source: IFS, Eurostat & WIIW
15
01_2006_4142_txt_EN.indd 15 12-07-2007 10:43:10
as it determines the incentives according to which economic decisions are made and
hence the output that is created out of any given set of resources
16
.
Before delving into the drivers of growth, this chapter will therefore first review in
section 2.1 the reforms to the institutions underpinning China`s economic development.
Section 2.2 sketches the contribution of capital, labour and residual factors in a classical
growth-accounting framework. The remaining sections examine in more detail some
critical components of China`s current growth performance, namely the contribution of
the private sector (section 2.3) and Foreign Direct Investment (section 2.4). The chapter
closes with a discussion of components which will become important for sustaining
China`s growth performance in the future, namely the high-tech component in China`s
growth (section 2.5) and the development of an indigenous Chinese Science &
Technology base (section 2.6).
2.1. The economic policy framework for growth
Departing from the (economically) inefficient ideological foundations and institutional
arrangements of the Maoist era, China has since the late 1970s embarked on a
comprehensive programme of economic reform, with its open door¨ policy as the
centrepiece. Following Deng Xiaoping`s southern trip with the proclamation of a
socialist market economy¨ in 1992, major changes were introduced, which kick-started
China`s growth. Box 2.1 gives an overview of the most instrumental reforms for
economic development.
Box 2-1: Lists of major reforms for economic growth
1978 "Open door" policy initiated, allowing foreign trade and investment to begin
1979 Decision to turn collective farms over to households. Township and village
enterprises (TVEs) given stronger encouragement
1980 Special economic zones created
1984 Self-proprietorships (getihu) encouraged, of less than 8 persons
1986 Provisional bankruptcy law passed for state-owned enterprises
1987 Contract responsibility system introduced in state-owned enterprises
1988 Beginning of retrenchment of TVEs
1990 Stock exchange started in Shenzhen
1993 Decision to establish a "socialist market economic system"
1994 Company law first introduced
Renminbi begins to be convertible on current account
Multiple exchange rates ended
1995 Shift to contractual terms of life-long employment for state-owned enterprise staff
1996 Full convertibility for current account transactions
1997 Plan to restructure many state-owned enterprises begins
1999 Constitutional amendment passed explicitly recognising private ownership
Regulation on unemployment Insurance
2001 China accedes to the World Trade Organisation (WTO)
2002 Communist party endorses role of the private sector, inviting entrepreneurs to join
2003 Introduction of (or decision on) a social security system
2004 Decision to "perfect" the socialist market economic system
Source. OECD (2005), ILO (2003).
16
For the importance of Incentives, Institutions and Infrastructure¨, see Rodrik, Subramanian and
Trebbi (2002)
16
01_2006_4142_txt_EN.indd 16 12-07-2007 10:43:10
Private enterprises have since the beginning of reforms been regarded as an essential part
of the Chinese version of a socialist market economy. Domestically, a framework for
private enterprises was created with a new company law in 1994. The state sector of the
economy was also modernised through the introduction of public corporations and the
listing of a number of these companies on the newly created stock markets in Shenzhen
and Shanghai. In 1999, the national constitution was amended to explicitly recognise
private property rights.
But perhaps the most important factor for China`s take-off has been its openness to
foreign trade and investment. The economy was decisively opened by encouraging
foreign investment, reducing effective tariffs on imported inputs (especially when used
for export production) and abolishing multiple exchange rates and introducing
convertibility for current account transactions. Non-tariffs barriers have been reduced
too, but remain pervasive. The accession to the WTO in 2001 was a very decisive step,
which placed China firmly on the world stage and provided an impetus and commitment
for the reform process.
Box 2-2: Economic Impact of China`s WTO accession
On 11 December 2001, China became the 143rd member of the World Trade Organisation, after over 15
years of negotiations. As a new member, China committed itself to a camprehens/re package af (rade
and /nres(men( //bera//sa(/an, phased in over a period of two to five to ten years. The major commitments
were to reduce tariff and non-tariff restrictions
17
; limit farm subsidies
18
; provide full trading and
distribution rights to foreign firms; liberalise the oil sector and open up its services sector.
19
In addition,
the protocols of accession included signing up to the WTO`s intellectual agreement on protection of
patents, copyrights and trademarks, stipulations to increase the transparency of China`s trade regime and
procedures for the judicial review of administrative actions. It also requested state-owned enterprises to
make their purchasing decisions on commercial grounds only. China`s WTO partners, on the other hand,
have undertaken to eliminate quotas on China`s textile and clothing exports by 2005 (MFA), subject to
special safeguard provisions through to 2008. It also maintains the anti-dumping methodology, treating
China as a non-market economy, for 15 years after WTO accession.
On average, the ex an(e pred/c(/ans on effects from WTO accession were that after short term adjustment
costs, WTO accession would in the long term be unambiguously positive for China`s economy, adding a
growth dividend of around 1.3% per annum.
20
On the cost side, short-term disruptions were expected from
increased international competition in the form of rising bankruptcies and displaced workers. These costs
are more concentrated in highly protected sectors, dominated by inefficiently run SOEs. Also China`s
agricultural producers are major losers from tariff and subsidy cuts. But also Telecommunications and
Banking, in services, and Automobiles and Steel, in manufacturing,, were among the sectors expected to
suffer most. On the benefit side, the long-term growth effects are more dispersed across sectors and agents.
These benefits come from increased investment and competition, leading to higher overall productivity
growth, particularly in those sectors where China holds a comparative advantage. At the macro-economic
level, China`s accession was expected initially to lead to a deterioration of its current account as imports
grew. This should however improve again in the medium term, following China`s restructuring effort. The
capital account however was expected to be affected positively from increased inflows of FDI, such that
the overall balance of payment was expected to increase after accession.

17
e.g. average tariffs on non-agricultural products to be reduced over five years from 18.5% to 9.4%; on
agricultural products from 20% to within the range 9-18%..
18
Spending on farm subsidies capped at 8.5% of the value of domestic farm production.
19
Banking, distribution/retail, insurance, securities, telecommunications. See Lehman Brothers (2002)
for a full list.
20
Based on an average of some ten studies, including IMF & World Bank, see Lehman Brothers (2005).
17
01_2006_4142_txt_EN.indd 17 12-07-2007 10:43:10
Taking stock of China`s perfarmance ex pas(, after WTO accession, the evidence shows a remarkable
resilience on the part of the Chinese economy to absorb the short-term losses, with a persistent overall
growth rate and steady unemployment rate since accession, as the following sections will demonstrate.
China`s WTO accession seems to have caused more havoc outside China, with the US and the EU
reimposing quotas on some Chinese exports.
To date, implementation of China`s WTO commitments has by and large remained on track, with the
average (unweighted) tariff rate continuing to decline to 10% in 2005 and key commitments with respect to
banking, trade and distribution rights having moved forward.
21

That said, there are cancerns among other WTO members that Non-Tariff Barriers remain high, resulting
in effective market access remaining difficult for foreign companies, particularly in sectors which China
has selected as strategic¨, e.g. banking. Particularly, issues related to IPR, local procurement, local
content regulations, local standard setting, registration and certification requirements and procedures,
remain on the list of concerns (cf below)
There are also concerns that China is not yet properly playing a more constructive role in the Doha Round
negotiations, in line with its growing economic importance. Having benefited greatly from trade
liberalisation, it should now, being inside the system, accept responsibility for further pushing trade
liberalisation globally.
The fixed exchange rate of the Renminbi and its role in the open-door policy to promote
export-led growth has been the subject of intense debate. The Renminbi`s value against
the US dollar had been maintained at a fixed level since 1995. With effect from 2005, its
value is set by reference to a basket of currencies. In practice, however, the Renminbi
still appears to be pegged to the dollar, with little de facto flexibility. China`s resistance
to pressures for a substantial real exchange rate appreciation has fed speculative capital
flows in anticipation of an eventual Renminbi appreciation. This in turn has led to a
surge in the accumulation of international reserves in China (for more on the Renminbi`s
revaluation, see Part II).
2.2. The contribution of capital, labour and other factors to growth
This section assesses the contribution of the various input factors for growth, using a
standard growth accounting framework. Investment, rather than private consumption,
has been the main source of demand growth in China. A crucial factor driving the
increase in GDP over the past two decades has been the accumulation of capital, as Table
2.1 clearly illustrates.
22
The contribution of capital represents around 5% of annual GDP
growth over the period under consideration. Most of this capital spending comprises
investment in fixed assets (capital construction),
23
reflecting the importance of the
industrial sector to China`s economic structure. Although government expenditures on
infrastructure have been important,
24
the capital accumulation was financed for the most
part by foreign investment and domestic personal sector savings. The investment boom
in recent years has been fuelled by cheap credit. Households, saving for future purchases
of education, health and housing, willingly hold bank deposits despite the weaknesses of
the banking system, but because of implicit deposit insurance by the government. This
provides abundant liquidity for banks to expand credit. Inflows of (speculative) capital

21
Lehman Brothers (2005).
22
OECD (2005)
23
About half of GDP in the first six months of 2005 represented investments in fixed assets (Source:
ITPS 2006).
24
Government expenditures on infrastructure have been substantial. In 2003, capital construction was
the largest item, representing about 14% of total government expenditures (cf Part II for more on
Government Expenditures).
18
01_2006_4142_txt_EN.indd 18 12-07-2007 10:43:11
have added to the liquidity in the banking system. Nevertheless, as will be detailed in
Part II, inefficiencies in financial markets are seriously limiting the contribution capital
can make to Chinese growth. Banks largely use their liquidity to finance investment by
state-owned enterprises.
Table 2-2: Sources of output growth
1983-1988 1989-1993 1993-1998 1998-2003
GDP growth 12.1 8.9 9.8 8.0
Employment contribution 1.5 1.0 0.2 0.3
Capital contribution 5.0 4.5 5.5 4.9
Residual factors 5.6 3.4 4.1 2.8
Of which.
Sectoral Change 2.2 0.8 -0.3 0.5
Education 1.0 0.9 0.9 1.1
Multi Factor Productivity 2.4 1.7 3.4 1.3
Source: OECD (2005) All numbers Percentage points
The contribution to growth made by employment. on the other hand, has been very
modest (<1% of GDP growth). Slowly decreasing labour participation rates, following on
from the restructuring of the economy, particularly within the state-owned enterprises
and the agricultural sector, as well as the expansion of education, are all factors in
explaining the low employment component. The kind of labour market reforms needed to
boost employment`s contribution to growth will be detailed in Part II.
The crucial role of human capital as a determinant of national growth is undisputed. The
increasing level of education of the labour force has contributed about 1% of GDP
growth over the past two decades (see table). The positive growth effects of human
capital are generated by boosting the skill levels of workers, equipping them to use new
technologies and improving their adaptability. According to the World Bank
Development Indicators 2006, China had, in 2004, about 70% of its population in the
relevant age cohort enrolled in secondary schooling, 15% in tertiary schooling
25
. This is
considerably higher than most developing counties, including India (with 52% and 11%
respectively), but still considerably below most developed countries, particularly with
regard to tertiary education (e.g. Germany has 100% and 50% respectively). China`s

25
The present education system was formed in the years between 1977 and 1980. Basic education
extends over 12 years, divided between 6 years primary education and 6 years secondary education.
China has 9 years compulsory education. The system is generally considered very competitive.
English is taught at all levels, starting from junior middle school, but the result is mostly a passive
language knowledge. Admission to all levels of education from high schools to PhD programmes
takes place on the basis of performance in admission examinations. The most critical is the National
College Entry Examination, which determines who gets access to higher education. In 2005, 8 million
pupils competed for just over 4 million positions in higher vocational and undergraduate university
education. In short, competition is fierce (NESO 2005).
19
01_2006_4142_txt_EN.indd 19 12-07-2007 10:43:11
leadership has understood the need for an educated and skilled workforce and has been
stressing the role of education since the mid 1990s, particularly higher education.
Overall financing of education increased from 2.8% of GDP in 1991 to 5.2% in 2002.
26
About 2/3 of this spending is public, while the remaining educational funds are generated
by privately paid tuition fees and non-government funding organisations (Opper, 2005).
Private education at all levels is a rapidly expanding industry in China. Though many
private schools offer good educational value, such as better facilities, they rarely rank
among the top schools in China.
The positive contribution of the sectoral change component reflects the shift out of the
highly inefficient agriculture sector. The contribution of these sectoral reallocations to
growth are however modest, particularly in the later periods, since the marginal workers
leaving agriculture, and moving mostly into manufacturing, are much less productive
than the average in the manufacturing sector, where they mostly move to, and the
catching-up process is a slow one.
Box 2-3: China`s Economic Structure
China`s economic structure is strongly focused on the manufacturing sector, as the following table shows.
The services sector is under-represented as compared to other developed countries. The agricultural sector
is over-represented as compared to other developed countries, but on a par with the stratum of middle
income countries.
Economic Structure, 2004 (added vaIue, share of GDP)
USA EU-25 China
Agricultural 1.6 6.1 14.7
Industry 23.1 27.9 50.9
Tertiary 75.4 69.9 33.1
Source. World Bank indicator (2005)
Ch/na's agr/ca/(ara/ sec(ar
Although the agricultural sector accounts for only a minor and shrinking part of Chinese GDP, the majority
of the population is still rural¨. Beyond farm jobs, the rural labour force is also in non-farm jobs, notably
in Township and Village Enterprises (TVEs), which are mostly privately owned. The decentralised rural
fiscal structure has distorted investment away from agricultural development into these TVEs.
The Chinese government, concerned by food security and poverty reduction, needs to improve agricultural
sector productivity. China`s WTO membership and pressure on RMB appreciation are adding to the
reform pressures, since cheaper agricultural imports are hurting China`s heavily protected agricultural
sector.
Fiscal reform is essential to re-energising the agricultural sector (cf below). Other policy instruments for
improving agricultural productivity are technological and scientific developments, price reforms providing
greater incentives to farmers, and land reform permitting private ownership of land.
The 11
th
five-year Programme (2006-2010) suggests that there should be more investment in rural
infrastructure and agricultural technology, continued reduction of the tax burden on the countryside,
improved rural public services (in particular education), a revitalised cooperative health system, and
protection of farmers` land rights against unfair expropriations of their land. Farmers should be allowed
freedom to sell or lease their land and there should be an end to restrictions on rural to urban migration.
The Plan however never indicates clear concrete policies to implement these broad objectives. Thus it
remains to be seen if and how it will be translated into action.
26
Cf infra for more on public spending on (higher) education
20
01_2006_4142_txt_EN.indd 20 12-07-2007 10:43:11
Ch/nese manafac(ar/ng sec(ar
China`s economic structure remains focused on manufacturing. China`s sectoral specialisation pattern is
moving beyond the traditional low-tech sectors. As the following table clearly shows, in the list of major
manufacturing industries, electronics and transport equipment are increasing their share in value added,
while textiles and food & drink are declining (for more on the Chinese Manufacturing Sector and its
evolving specialisation patterns, cf below).
Ch/na's serr/ces sec(ar
China`s service sector is, compared to other countries`, relatively less developed. In 2004, services
accounted for 33% of GDP.
27
This compares to around 75% for the US and 70% for EU-25. The service
sector is generally difficult to define and measure. In China`s case, the problem is even greater. All
statistics on services should be interpreted with great care. In December 2005, China`s official GDP figures
were revised, leading to a 17% larger GDP for 2004. The bulk of the revision (90%) is due to the tertiary
sector, and within service sectors, transport & communication¨, trade & catering¨ and real estate¨
account for more than three-quarters of the revision. As a consequence, in the revised figures, services
account for around 40% of GDP. However, even at the new revised figures, China`s service sector remains
a relatively small part of the economy compared with other countries.
The underdeveloped services sector has great potential for creating jobs. But much will depend on the will
of the government to deregulate the sectors, introduce more competition and open it up to foreign
participation, as stipulated in the WTO accession agreement (cf below).
China`s Manufacturing Structure: Share of Value added of Major Industries
2003 1998
Electronic & Telecom Equipment 9.5% 6.4%
Electric Equipment 5.2% 5.0%
Machinery 7.3% 7.7%
Chemicals (including pharma, rubber & plastics) 12.3% 12.3%
Food & Drink 7% 8%
Textiles, Clothing&Leather 8.8% 10%
Transport Equipment 6.9% 5.8%
Source: OECD (2005)

An important component of growth in output is Total Factor Productivity (TFP), the
residual component in a growth accounting framework, which is typically associated
with improvements in productivity and innovation. For China, the growth in TFP is
mostly due to the rise of the private sector in the economy, with enhanced efficiency as a
result. Section 2.3 will discuss the developments in the private sector. An important
factor in the increase of TFP from the private sector is its opening-up to world markets,
with both inflows of Foreign Direct Investment (FDI) and exports to world markets
providing important gateways for catching up on productivity growth. This will be
further detailed in section 2.4.
The slowdown in TFP growth in more recent years reflects a number of residual
challenges, attributed to insufficient flexibility in labour, capital and product markets to
stimulate productivity. This will be further examined in Part III.
2.3. The private sector
China's rise in the global economy today is driven by highly entrepreneurial forces in the
private sector. Facilitated by an increasingly tolerant (but not always supportive) policy
environment and reforms (cf section 2.1), private enterprises have outpaced public ones.
Value added by privately controlled companies now represents at least half of all value
added in the economy, as the following Table demonstrates.

27
Source: World Bank Development Indicators 2005
21
01_2006_4142_txt_EN.indd 21 12-07-2007 10:43:11
Table 2-3: Private versus Public sector in the Chinese economy: % of value added
by firm ownership
1999 2001 2003
Private Sector 51.5 55.5 59.2
Public Sector 48.5 44.5 40.8
State-controlled 37.1 35.7 33.7
Collectively controlled 11.3 8.8 7.1
Total (100 % of GDP) 100 100 100
Source: OECD, 2005 (Economy wide)
Note: A considerable amount of uncertainty surrounds any estimates of the private sector in China due to
the difficulty of determining which enterprises are controlled by private entities. The OECD uses a
relatively strict definition of private enterprises: only firms that are not identified as being public-
controlled (state or collective controlled) are classified as forming the private sector (OECD, 2005).
Private ownership has become widespread across industrial sectors. While in 1998, the
private sector produced the majority of value added in only five industrial sectors, by
2003 this was true for all manufacturing industries.
Table 2-4: China`s Manufacturing Structure: Share of Value added by Private
Sector in Major Industries (2003)
Electronic & Telecom Equipment 74%
Electrical Equipment 77%
Machinery 63%
Chemicals
(including pharmaceuticals, rubber & plastics)
60%
Food & Drink 69%
Textiles, Clothing & Leather 82%
Transport Equipment 33%
Source: OECD (2005)
With the exception of transport equipment, which is still mostly state-controlled, all the
major sectors are mostly privately controlled. Beyond manufacturing, the state also
remains dominant in mining and utilities. In service sectors the experience has been
mixed. Distribution has also become increasingly private, but the penetration in other
tertiary sectors - e.g. financial services - is lagging behind (see below).
28

28
Most services remain dominated by state monopolies in telecommunications, banking, health care,
tourism, transportation, logistics, utilities and others. Due to the poor quality of the services statistics,
in what follows, we will restrict the discussion to industrial sectors, unless otherwise stated.
22
01_2006_4142_txt_EN.indd 22 12-07-2007 10:43:12
The increasing share of the private sector has improved economic performance, as the
private sector is more efficient than the state-controlled sector. According to OECD
(2005), capital intensity in the private industrial sector is one-third that of the public
industrial sector, but labour productivity is just 15% less. TFP in private sector
companies, after taking into account the impact of firm size, location and industry
affiliation, is double that in directly state-controlled firms. As a consequence of higher
TFP and lower capital output ratios, the profitability of the private sector has been
growing, despite increasing liberalisation and market competition. Along with
profitability, private sector employment has been growing, offsetting the large and
continuing decline in state sector employment.
One important factor to explain higher productivity is the private sector`s openness to
competition on world markets. Many private firms are engaged in processing imports,
i.e. imports of inputs from abroad, which are used to produce goods for exports. But
perhaps more important is the role played by Foreign Direct Investment in China.
Foreign owned firms are not only characterised by higher productivity levels, they also
stimulate productivity in local firms through technology spillovers and competition.
Trade patterns will be examined in chapter 3. The next section will review the role of
FDI in China`s development.
2.4. Foreign Direct Investment
China`s integration in the global division of labour has probably been the most important
element of the recent economic development process. Foreign Direct Investment (FDI)
was the catalyst to bring China`s economy back onto the global stage. Initially, this FDI
was mostly aimed at developing export oriented activities, with China benefiting from
the import of capital, employment creation and exports, and from the modern technology
brought in by the MNEs. Later, FDI become more motivated by market access.
Currently, China is trading access to the Chinese market against foreign investors`
technological and organisational know-how.
2.4.1. The political framework for FDI
In 1980, China created special economic zones which were isolated from the prevalent
hierarchical system and allowed to adapt to fit into the world economy. Substantial
amounts of FDI quickly found their way into these enclaves, foreign trade picked up and
economic development took off. With the success of these first market-economy
enclaves, more and more regions were permitted to experiment with institutions and
institutional structures specifically designed to cater to the needs of international
economic exchange.
Foreign firms enjoyed preferential treatment with regard to property rights security and
taxes.
29
The level of property rights security granted to foreign firms in the 1982
constitution was only granted to private firms in 2004. At the moment, the official
preferential treatment of foreign direct investment has been dismantled.
Under an export-oriented development strategy, foreign firms were initially prompted to
export most of their production. Local content requirements were imposed to ensure
positive spillovers on the local economy from FDI. However, with more liberal FDI
29
Most foreign controlled companies pay a corporate tax rate on average of 21%, half that of domestic
companies, OECD (2005)
23
01_2006_4142_txt_EN.indd 23 12-07-2007 10:43:12
regulations resulting in better access to the Chinese market, and rising purchasing power
of (parts of) the Chinese population, the nature of FDI is gradually changing. Market
seeking¨ FDI is becoming more important and is expected to become the main mode of
China-bound FDI.
There have been ongoing improvements in market access following China`s WTO
commitments. In 2004, the Ministry of Commerce issued new rules that liberalise access
to the distribution services sector, and a new catalogue of encouraged, restricted, and
prohibited sectors was published at the beginning of 2005, increasing the number of
service sectors open to investment.
30
Moreover, restrictions on wholely foreign-owned
enterprises (WFOE) have been relaxed. For instance, in the 2001 revision of the WFOE
law, export requirements were dropped and technology transfer requirements were
relaxed. Nevertheless, market access for FDI is far from complete. Current rules on
public procurement continue to discriminate against foreign controlled companies
established in China. Also, local standard setting (e.g. in mobile phones), slow business
licence applications, opaque registration and certification procedures, and IPR issues
continue to hamper foreign firms` access to the local Chinese market.
31
Although these
remaining market access issues may simply reflect a still ongoing process of
liberalisation, there is some concern in the West that some of these NTB issues are more
structural¨ in nature, reflecting China`s increasing desire to rely on indigenous capacity
rather than FDI.
2.4.2. FDI Inflows and the Modernisation of China's Industry
2.4.2.1.The FDI Booms
It was not until China`s strong commitment to a market economy in the early 1990s that
the country was able to attract substantial amounts of FDI.
32
The first FDI boom¨ began
in 1992
33
and came to a halt in the turmoil of the Asian crisis (see Table 1). A short
period of consolidation was quickly followed by the take-off of the second FDI boom¨
rooted in China`s accession to the WTO in late 2001. Currently, China has become the
first destination for FDI in the developing world, absorbing 20-25% of all FDI directed
towards these countries (UNCTAD).
34

30
In some important (strategic) sectors, Joint Venture restrictions remain, such as (petro-)chemicals and
car manufacturing.
31
For instance in the banking sector, despite the improvements in opening up this market in line with
WTO commitments, the effective penetration of foreign banks remains very limited (cf below),
attributed to Non-Tariff Barriers. For example, the size and the nature of liquidity and capital ratio
requirements, as well as the restrictive licensing rules with regard to RMB transactions, reduce the
attractiveness of FDI for foreign banks in China.
32
Such a wait-and-see attitude is consistent with the experience among other developing economies. Due
to insufficient market information foreign investors delay their investment decisions until pioneer
investors provide them with further insights into the market environment and the reliability of the host
countries` FDI policies.
33
In 1992, the first year of substantial FDI inflows to China, FDI flows to South Korea and Chinese
Taipei dropped by 31% and 51% respectively, thereby pointing at a considerable diversion effect in
China`s favour (UNCTAD). It should also be noted that the upswing of FDI inflows to China
coincides with a general increase in FDI flows to developing countries. Average annual flows directed
towards developing countries in 1990-1993 were double those of 1987-1989 (UNCTAD, 2003).
34
The outstanding position of China remains unchallenged even bearing in mind that part of the
resources classified as inflowing FDI has in reality been round-tripping¨ money, i.e. money that had
24
01_2006_4142_txt_EN.indd 24 12-07-2007 10:43:12
Table 2-5: Trends in China`s Share in World FDI flows
1985-1995 1997 1998 1999 2000 2001 2002
China 11.7
(6.5%)
44.2
(9.3%)
43.8
(6.3%)
40.3
(3.7%)
40.8
(2.7%)
46.8
(8.7%)
63.0
(9.3%)
USA 44.4
(25.5%)
103.4
(21.6%)
174.4
(25.1%)
283.4
(26.0%)
300.9
(20.2%)
124.4
(19.4%)
63.0
(9.3%)
World 181.1 478.1 694.5 1088.3 1491.9 818.0 681.0
Source. United Nations Conference on Trade and Development (Unctad).
In relative terms, the scale of the inflow of FDI for the Chinese economy has been large,
amounting to 6% of GDP in the early 1990s, falling back to 3.5% since 2000 (although in
absolute terms, the flows have continued to increase). The fall back in relative
importance can be explained by the worldwide recession¨ in FDI flows, cf above, but
also by a shift in policy towards more reliance on domestic firms in selected sectors, like
Information & Communication Technology (ICT) (cf below). It picked up again after
2000.
In China foreign firms have generated rates of return on FDI which are significantly
higher than developing economies` average returns. One third of China`s FDI inflows in
1999-2001 came from reinvested earnings.
35
Figure: Rates of Return on FDI, 1999-2001
1999 2000 2001
China 5.6 6.2 5.8
Hong Kong 13.6 12.5 11.5
Developing Economies Average 4.6 4.3 4.2
Developed Countries Average 7.4 7.1 5.7
Source: Unctad (2003).
Although the growth in total inflows of FDI into China has been impressive, a closer
look at where the inflows are coming from (2.4.2.2) and where in China the flows are
going to (2.4.2.3.) puts in perspective somewhat the importance of FDI for the overall
development of the Chinese economy.
2.4.2.2. FDI inflows by country of origin
The bulk of China`s massive FDI inflows have originated not in the world economy`s
centres of technological growth. The Triad economies of the EU, Japan and the USA
have each accounted for only about 10% of all China-bound FDI. This means that the
stock of Western investment is much lower than might have been expected.

been illegally brought out of the country in the first place and then brought back under the label FDI¨
in order to benefit from special incentives reserved for foreign investment enterprises (cf below).
35
UNCTAD (2003).
25
01_2006_4142_txt_EN.indd 25 12-07-2007 10:43:12
Figure 2-1: FDI into China by Country of Origin
Note: 2005 excluding November-December.
Source: Science Statistical Yearbook, various issues; adapted from Clegg (2005)
Hong Kong, Taiwan and South-East Asia have been the most important investors in
China. Part of this investment is so-called round-tripping¨ in search of preferential
treatment,
36
which puts into perspective the use of FDI as a mechanism for importing
technology. Nevertheless, a substantial and growing share of FDI into China, even from
Hong Kong and Taiwan, is a source of technological know-how for the Chinese
economy. The overwhelming majority of Hong Kong and Taiwan invested enterprises in
China are engaged in export processing activities. Taking advantage of the
complementarity of their respective resource endowments, Hong Kong and Taiwan have
each established very close economic relations with China, transferring their labour
intensive production facilities to the Chinese mainland, as the following Box details.

36
Although it is difficult to measure exactly the share of round-tripping in China's FDI inflows, it
accounts for a large proportion of China's FDI inflows coming from Hong Kong or overseas tax
havens such as the British Virgin Islands, Bermuda and Cayman Islands. A 2002 report by the
International Finance Corporation (IFC) of the World Bank put the estimates at 30-50% of the total in
2000. And the market's general assessment is that the ratio has declined from 30% to around 10-20%
in recent years.
26
01_2006_4142_txt_EN.indd 26 12-07-2007 10:43:15
Box 2-4: The economic presence of Hong Kong and Taiwan on the mainland
Hong Kong
Hong Kong has established a pattern of economic interaction with China that is characterised by a very
high degree of interdependence, de facto merging the Chinese Pearl River Delta and Hong Kong into a
highly integrated economic region.
37
This economic nexus between China and Hong Kong, which in the
1980s and early 1990s primarily relied on individual entrepreneurial activity and was lacking a formal
institutional framework, has in recent years been put on a sound institutional foundation. On 1 January
2004 the first stage of the Closer Economic Partnership Agreement (CEPA) between China and Hong
Kong came into effect. From then on zero tariff rates applied for a large and expanding range of goods. In
addition Hong Kong companies now benefit from deregulation in 18 service sectors going beyond China`s
final WTO commitments as well as current WTO phase-in requirements. These sectors include
management consulting, convention services, advertising, accounting services, real estate and construction,
medical and dental, distribution services, logistics, freight forwarding agency services, storage and
warehousing services, transport services, tourism services, audiovisual services, legal services, banking,
securities insurance and value-added telecommunication services.
Taiwan
There is no formal institutional foundation for economic interaction between China and Taiwan. Moreover,
there are no direct transport, trade and postal links, although since 1997 ships have been allowed to sail
directly between certain ports if they do not carry local cargo. Also, indirect sea links have been
liberalised,. While the remaining restrictions are cumbersome and increase transaction costs, it is the
restrictions on flows of capital and people that seriously prohibit deeper economic integration.
Nevertheless, since the late 1980s Taiwanese entrepreneurs have been moving to mainland China. Relying
on informal arrangements and entrepreneurial savvy for circumventing government restrictions they have
been transferring complete value-chain segments to mainland China in order to uphold their cost
competitiveness on global markets. The business sector maintaining the closest links to mainland China is
Taiwan`s electronics industry. After concentrating their investments in Fujian province just north of
Taiwan in the early stages of development, Taiwan`s electronics companies have also established an
electronics industry cluster in the Suzhou area (Jiangsu province) that builds on experience acquired in
Taiwan`s Taipei-Hsinchu electronics corridor.
Source: Adapted from European Commission (2005a).
2.4.2.3. Regional Distribution of FDI Inflows within China
The distribution of FDI within China differs widely between regions. FDI inflows have
been heavily concentrated in the coastal provinces (the Eastern region), while the Central
and Western regions have attracted only marginal shares.
38
About one third of China`s
total industrial output by all foreign firms is created in the province of Guangdong and
another third in the Shanghai-Jiangsu-Zhejiang growth triangle (OECD, 2000,
MOFCOM). The industrial output value of foreign funded enterprises, excluding those
with capital from Hong Kong, Macao and Taiwan however, is first of all generated in the

37
The high intensity of economic interaction is facilitated by a fixed exchange rate between the
Renminbi and the Hong Kong Dollar. With the HK$ pegged to the US$ at a rate of 7.8 to the dollar,
and the Renminbi (at least in recent years) being de facto pegged at a rate of 8.28 to the dollar, the two
currencies are upholding a fixed exchange rate to each other. Due to this triangular relationship any
changes in the exchange rate between the Renminbi and the US$ must have a non-trivial impact either
on the exchange rate regime of Hong Kong or on relative prices, i.e. on the structure of economic
interaction between China and Hong Kong.
38
Furthermore, there is no sign of diminishing regional disparities. In 2003, 89% of FDI into China still
went into the Coastal Region, and only 8% into the Central Region, and 3% in the Western Provinces,
Clegg (2005).
27
01_2006_4142_txt_EN.indd 27 12-07-2007 10:43:16
triangle, which accounts for nearly 40% of the total.
39
The high and persistent
concentration of FDI in the coastal region is an important factor contributing to
the persistent regional income disparities within China, and will be further discussed in
part II.
40
2.4.2.4. FDI inflows by sectoral affiliation
The distribution of China`s FDI inflows to various sectors does not follow market
parameters alone, but remains quite heavily regulated by the Chinese government. The
Foreign Investment Industrial Guidance Catalogue¨ outlines in which industries foreign
investors are welcome, restricted or not permitted. Today, FDI excluded or restricted
sectors include financial services, air transport, media and electricity.
As documented in the following table, foreign firms have a strong presence in the
production of electronic and telecommunication equipment, office machinery, leather
and sports goods, furniture, garments and plastic products. These goods are produced in
predominantly labour-intensive production processes.
Table 2-6: Share of Foreign Enterprises in China`s Industrial Production
Gross Industrial Output Value by Sector 2003
Share
Electronic and Telecommunications Equipment 73.4%
Instruments, Meters, Office Machinery 61.8%
Leather, Furs, and Related Products 53.2%
Furniture Manufacturing 47.3%
Garments and Other Fibre Products 45.3%
Plastic Products 41.9%
Food Manufacturing 39.6%
Rubber Products 36.6%
Metal Products 35.9%
Electric Equipment and Machinery 33.1%
Transport Equipment 31.8%
Beverage Manufacturing 30.2%
Textile Industry 22.1%
Raw Chemical Materials and Chemical Products 22.1%
Medical and Pharmaceutical Products 22.1%
Source: European Commission (2005a).
FDI into China is strongly concentrated in manufacturing. Although the inflows of
foreign funds are beginning to shift into service sectors, in 2003 64% were nevertheless
invested in manufacturing and only 23% in services, of which half is accounted for by
real estate management.
41
This low share of services is mainly due to a policy bias that

39
On the provincial level Guangdong seems to be in a class of its own. During the 1980s Guangdong
absorbed nearly half of all the FDI China attracted during this period. In Guangdong itself FDI has
been highly concentrated in a few localities (i.e. the Pearl River Delta and the Shantou area). In
Guangdong enterprises with capital from Hong Kong, Macao, Taiwan generate nearly 50% of their
industrial output value in Guangdong, while foreign firms generate only 20% of their national total in
Guangdong.
40
The persistence of FDI concentration is partly explained by agglomeration economics. New FDI
prefers to locate close to existing FDI to benefit from externalities, such as joint infrastructure,
networks of suppliers and customers, etc.
41
China Statistical Yearbook (2004).
28
01_2006_4142_txt_EN.indd 28 12-07-2007 10:43:16
promoted foreign investment in traditional industries, while restricting foreign
participation in services. Foreign ownership in banking is expected to increase after
2005, depending on how swiftly market access barriers are lifted.
42
In other service
sectors like telecommunications and securities, foreign participation is more likely to
remain limited.
Table 2-8 indicates that the top two sectors with respect to FDI are ICT sectors. The next
section will examine in more detail ICT and more generally Chinese High-Tech
Manufacturing and the contribution of FDI towards growth in these sectors.
2.5. China`s high-tech industries and the role of FDI
China`s economic policymakers are aware that China being the global centre for labour
intensive, low skilled manufacturing will not be sufficient to sustain growth performance
in the longer term. While industries establishing labour intensive production capacities in
China are important, as they create jobs for China`s population and facilitate the task of
economic restructuring, the current focus of China`s industrial policy is on promoting
and establishing higher value added, technology intensive industries.
China`s high-tech industries still lag behind those of developed countries, but they are
growing rapidly. Their contribution to manufacturing value added increased from 6.2%
to 9.3% over the period 1995-2000, still very much below US values (21%), but coming
close to Italy (9%), Germany (11%) and France (14%).
43
High-tech sectors are contributing substantially to the strong growth performance. These
sectors typically have a higher productivity than other sectors, related to higher R&D
investments. For China, R&D expenditures as a share of value-added in high-tech
industries was 2.4% in 1996, increasing to 4.4% in 2003. In the electronic and telecom
sector the R&D-to-value-added ratio is 5.4%. This is still below international levels in
these sectors, but catching up.
The growth in China`s high-tech has a strong international dimension. China has been a
prolific importer of technology embodied in goods.
44
It has been less active as an
importer of disembodied technology, which entails royalty or other licensing fees.
45
The
most important mechanism used by the Chinese government to bring in foreign
technological know-how is by encouraging foreign investment in high-tech sectors. As a
consequence, foreign-owned firms now play an important role in Chinese high-tech
industries, accounting for more than half of total high-tech firms. Nevertheless, there are
substantial differences across the various industries. Foreign presence is particularly high
in computers and office equipment and in electronic and telecom equipment, not so much
in air and spacecraft and pharmaceuticals.
The entry and presence of foreign firms bring China not only production facilities but
also R&D sources, as reflected in the R&D expenditures by foreign-owned firms.
Foreign firms are quite active in R&D in some high-tech sectors, such as computers and
42
Under the WTO accession agreement, foreign banks are allowed to take a 20% ownership in local
banks, conditional on not exceeding 25% total foreign participation.
43
The OECD classifies as high-tech industries Air & Spacecraft (353), Pharmaceuticals (2423), Office
machinery (30), Radio, TV & communication equipment (32), Instruments (33).
44
High-Tech imports accounted for about 30% of total Chinese imports in 2003.
45
China spends about 12% of what Korea spends as a share of GDP on licensing foreign technology
(World Bank (2002)).
29
01_2006_4142_txt_EN.indd 29 12-07-2007 10:43:16
electronics. Nevertheless, domestic firms are the major players in terms of R&D input in
China`s high-tech industries. The R&D intensity (R&D expenditure to value-added
ratio) of foreign firms is only about half of that of domestic firms (See figure 2.2). This
low level of foreign R&D puts into perspective the use of FDI by China as a mechanism
to get access to foreign technology
46
This can be correlated to a reluctance on the part of
American, European and Japanese firms to locate R&D in China. Under unclear IPR
regimes, when it is difficult to keep know-how proprietary, foreign firms will prefer to
leave most of their core R&D at home when locating in China.
Figure 2-2: Ratio of R&D expenditure to Value-added by Ownership
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Nevertheless, foreign firms from high-tech industries increasingly (have plans to) locate
R&D in China. Although the exact number of these foreign R&D centres is not clear, the
evidence suggests that they are increasing rapidly. For example, US outward R&D
investment in China has grown by 25% annually since the mid 1990s (against 8% per
year in EU-15), making it the fastest growing destination for outward R&D investment.
47
Survey data on FDI intentions further indicate that China is high on the list of planned
R&D investments. For example, a global survey conducted by the Economist
Intelligence Unit in 2004 showed that top companies` favourite location for planned
R&D investment was China, followed by the US and India. UNCTAD has also found
46
Indeed, Guo & Veugelers (2005) find no evidence of positive spillovers from R&D-FDI on local
Chinese firms` productivity.
47
In addition, patents owned by US assignees but invented abroad, although only 12% of total USPTO
patents, are the fastest growing component of US patents. In these foreign invented US patents, the
EU is still the biggest destination, but Asia (excl Japan) is the fastest growing component of foreign
invented US patents (R&T Management (2005)).
3: 22 .
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30
01_2006_4142_txt_EN.indd 30 12-07-2007 10:43:17
that while the US is the top destination in developed markets, China is a top destination
among developing countries.
48
Due to recent WTO-related reforms, foreign high-tech enterprises are now in many cases
allowed to establish wholely foreign-owned subsidiaries in China, which are more
attractive than joint ventures for conducting R&D, since they are more effective at
keeping core know-how proprietary. This is of particular relevance in China, given its
weak enforcement of intellectual property rights. Hence, foreign firms are currently
consolidating their earlier research-related programs into whole-owned subsidiaries while
simultaneously shifting toward more advanced R&D activities.
Locating R&D in China is motivated by the need to be close to the large (potential)
Chinese market. But also access to the local base of Science & Technology know-how -
, particularly, the large pool of engineers and scientists - is a major pull-factor for
attracting foreign R&D investments.
2.6. China`s Science & Technology
Initially China`s development was focused on importing foreign technology and capital
through FDI, allowing China to catch up quickly. These foreign firms were exporting
most of their production to the world market. More recently, however, with a more
developed and growing internal market and having moved closer to the technology
frontier in a number of sectors, most notably in ICT, China has embarked on a new phase
of development, relying increasingly on indigenous productive capacity. As Chinese
enterprises get closer to the world frontier, being globally competitive will require
investing more in R&D, not only to scan for, acquire and adapt foreign technology, but
also to develop their own R&D capabilities in core areas of activity.
2.6.1. China's striving for S&T development
The importance the Chinese authorities attach to innovation is unprecedented. President
Hu stated at the National S&T Conference in Beijing in January 2005 that the goal was to
transform China into a nation of innovation in 15 years. This section will evaluate how
far China has already progressed with regard to its own indigenous innovative potential.
The challenges China is still facing reaching achieving this objective will be discussed in
Part II.
China`s Science & Technology base has grown rapidly, as illustrated by the following
table. With a real annual growth rate in R&D expenditures of more than 15% per year,
despite the strong growth in Chinese GDP, gross expenditures on R&D (GERD) as a
share of GDP have increased from 0.7% in 1998 to 1.3% in 2003. This compares to 1.9%
in the EU-25 in 2003
49
and 2.6% in US. If these trends in the EU and China continue,
China will be spending the same amount of GDP on research as the EU in 2010 - about
2.2%.
Table 2-7: Some S&T input indicators for China
1998 1999 2000 2001 2002 2003
GERD as % of GDP 0.7 0.83 1.00 1.07 1.22 1.31
48
Unctad (2005).
49
This is already higher than Spain 1.05%, Italy 1.14%, Ireland 1.16%, but still lower than UK 1.9%, France 2.2%,
Germany 2.5% (Source: Eurostat)
Real annual growth (%) 10.9 20.3 16.9 15.0 23.8 17.2
Source: Science Technology Statistics, China
31
01_2006_4142_txt_EN.indd 31 12-07-2007 10:43:17
Enterprises accounted for 62.4% of GERD in 2003, while 26% is done by R&D
institutions, and 10.5% at Higher Education institutions. Not surprisingly, high-tech
manufacturing and particularly ICT takes up the bulk of Chinese business R&D
investments: R&D expenditures in electronic and telecom account for 62.3% of total
R&D in China 2003, computer equipment for another 11.5%. The pharmaceutical sector
only accounts for 12.5%.
In line with overall Chinese development, R&D investments are heavily regionally
concentrated. The top five Regions (Beijing, Guangdong, Jiangsu, Shanghai and
Shandong) account for 53% of total expenditures on R&D, with Beijing accounting for
17% of GERD2003.
Although industrial investment in R&D is important and growing, the Chinese
government remains an important financer of research. The next two sections will focus
on government investment in S&T programmes (2.6.2) and on development of human
capital (2.6.3) as major drivers of China`s S&T growth trajectory.
2.6.2. Government funding of S&T
China`s public investment in S&T represents 4% of total government expenditures
(975.5 million Yuan) and 0.8% of Chinese GDP in 2003. The Chinese government funds
R&D through five major programmes, most of which were established in the 1980s.
Government funding is concentrated on specific fields selected for their potential
contribution to China`s development, such as IT, energy, biotech, along with national
security (aerospace and laser) and fundamental science & frontier research, as the
following Box documents. Each of the programmes supports a close science-business
interface in order to secure innovation activities with good prospects for productivity
growth and to maximise the commercialisation of R&D output.
Box 2-5: Major Chinese Government R&D Funding Programmes
The Key Technologies R&D Programme, the most important one in terms of total funding, was launched in
1982. It covers agriculture, electronic information, energy resources, transportation, materials, resources
exploration, environmental protection, medical and health care, and other fields. It is the largest national
programme and funds research at more than 1000 scientific research institutions.
The 863 Programme, having started in 1986, looks at 20 areas selected for their high potential to contribute
to industrial development. It includes space flight, laser, automation, energy, new materials, and marine.
The 973 Programme is directed at basic research and began in 1998. It represents China`s increasing
support for basic knowledge creation and focuses on interdisciplinary scientific research in areas such as
agriculture, energy, information, environment and resources, population and health and materials.
The Torch Programme is aimed at developing high-tech industries and was launched in 1988
50
. It is
product oriented and includes the establishment of high-tech industrial development zones, the stimulation
of funding by banks and the development of management skills among technical personnel. The projects
centre on emerging fields such as new materials, biotechnology, electronic information, integrative
mechanical-electrical technology, and advanced and energy-saving technologies.

50
Legend/Lenovo is one of the examples of firms having benefited from the Torch Programme.
32
01_2006_4142_txt_EN.indd 32 12-07-2007 10:43:17
The Spark Programme began in 1986 and is aimed at revitalising the rural economy through science and
technology. It includes mostly demonstration projects.
Beyond merely increasing spending, China has also improved the efficiency of its
investments in public R&D. While initially the allocation of funds was exclusively top-
down government led, the procedure for allocating S&T funds was replaced in 1985 by
public competition and peer review, with the potential for the commercialisation of S&T
output as a major criterion for funding decisions. Also universities and public research
institutes have been reformed to increase their R&D efficiency (for more on this, see part
II, Chapter 9).
2.6.3. Human Capital for S&T. tertiary education
An important component of S&T growth in China is its huge pool of human capital for
R&D. This is an important attractor for enterprises (both local and foreign) and research
institutes for investing in R&D activities in China. Scientists & Engineers (S&E), active
in R&D have increased rapidly. China now has the second highest number of researchers
in the world (18% of total world stock), still behind the US (23%), but ahead of Japan
(14%)
51
.
Table 2-8: Human Capital for S&T input indicators for China
1998 1999 2000 2001 2002 2003
R&D Personnel (1000 FTEs) 755 822 922 956 1035 1095
S&E (1000 FTEs) 485 531 695 742 811 862
S&E engaged in R&D per 10000 labour force 6.7 7.3 9.4 10 10.8 11.3
Note. FTE=Full Time Equivalent
Source: Science Technology Statistics, China
Stimulated by increased funding and reforms in the higher education system, which took
off in the main only in the late 1990s, the number of new students in the higher education
system increased over tenfold between 1978 and 2004, but with the biggest rise after
2000. Yearly intake in the period 2000-2004 was 10 times higher than in 1978-1999. In
addition, success rates have increased and further boosted the number of graduates and
post-graduate students. As a consequence average yearly intake in graduate and post-
graduate programmes increased tenfold after 2000 (Shichor (2006)). While according to
World Bank Development Indicators, China had in 2004 about 15% of the relevant age
cohort enrolled in tertiary education, the long-term plan is to increase the entrance rate of
the age cohort (19-21) into higher education to 55% in 2050 and to increase the share of
higher education in the workforce to 44% in 2050 (Chinese Education and Society
(2005)).
Due to China`s centralised system of university entry exams, the structural composition
of university graduates can be closely aligned to the specific needs of China`s economic
development. In 2004, the majority of China`s postgraduate students were in either
engineering (39%) or science (12.5%). This makes China a top producer of engineers
worldwide, along with the US. China is considerably weaker in social sciences and law.
China`s revolution in higher education reflects large-scale investment. In 2004 most
higher education funds came directly from the central government (nearly 47%).
51
Research & Technology Management (2005)
33
01_2006_4142_txt_EN.indd 33 12-07-2007 10:43:17
Nevertheless, nearly 30% of higher education funding came from tuition fees, a
remarkable high percentage, particularly for a socialist market economy.
To meet the huge demand for higher education, the Chinese government supports non-
state/private entities in setting up and running educational institutions.
52
These private
institutions, usually located in provincial urban areas, derive revenues from tuition and
offer a limited range of professional courses and programmes. At present there are 214
private institutions of higher education, mostly offering vocational education. Only a
handful offer Bachelor degrees. To ensure that all students, including the poor, have
access to higher education, the Chinese governments, universities and banks have set up
special financial support systems for poor students, which include scholarships, loans and
tuition waivers.
53
In a similar fashion, the Chinese government encourages foreign higher education
providers to set up shop in China.
Box 2-6: Foreign Providers of Higher Education
Foreign universities are seen by the Chinese as contributing to the expansion of the domestic higher
education capacity, providing an opportunity to attract modern and advanced teaching methods and
curricula, as well as expertise in management of higher education institutes. Nevertheless, the activities
and involvement of foreign universities in the Chinese education market are strictly regulated, e.g. the 2004
Implementation Guidelines for the Provisional Regulations regarding the Sino foreign Joint Running of
Schools¨. For instance, foreign providers are not allowed to operate independently; they may only offer
their programmes in cooperation with recognised Chinese institutions. The vast majority of active foreign
universities in China are from the US, Canada, Australia and the UK. Continental European universities
account for only a very small portion of foreign programmes on offer in China (NESO, 2005).
The growth of the Chinese S&E base has been accompanied by a series of measures and
policies designed to foster the international mobility of human resources in Science &
Technology. The Chinese government greatly encourages international cooperation and
exchange, including student mobility.
According to Statistics from the China Scholarship Council, between 1978 and 2004,
814 884 Chinese students went abroad for studies. 197 884 (i.e. almost 25%) have now
returned. The number of students going abroad has skyrocketed particularly since the
end of the 1990s. In 2004, about 115 000 students left the country to take up studies
overseas. More than 90% self-financed their foreign studies. A prime destination for
Chinese students is the US. According to the OECD (Educational Database), about 35%
of the total number of Chinese students enrolled in OECD countries study in the US.
The EU-based share has been growing and in 2002 accounted for 23% of total Chinese
students studying abroad, similar to Japan`s share.
54

52
In addition, self-study is an important alternative for China`s ambitious but constrained young people
to move up (World Bank (2002)).
53
In 1994, tuition fees were introduced at public and private universities. At present, tuition fees for
public universities can be up to 10000 RMB, and up to 30000 RMB in private universities, depending
on the discipline (NESO 2005).
54
According to NSF (2004), Science & Engineering Indicators, in 2001, the group with the highest
growth rate in degrees awarded in the US was Chinese students. They accounted for 7600 new PhDs
in S&E in 2001 (compared to 118 000 to US citizens).
34
01_2006_4142_txt_EN.indd 34 12-07-2007 10:43:18
Box 2-7: China`s participation in Erasmus Mundus exchange of students and
scholars
The Erasmus Mundus Programme was launched by the European Commission in 2004 to foster co-
operation and mobility programmes in the field of Higher Education and to promote the EU as a centre of
excellence in learning. It provides, inter alia, scholarships for third country nationals, as well as
scholarships for EU nationals studying in third countries. The 808 students selected in 2005-2006 come
from 92 different countries, with China ranking second, after India (N=85). Of the 133 scholars selected,
China accounts for 23, second after the US. This represented a big increase over the previous year, partly
due to the Asian Window¨ earmarking since 2005.
Source: DG EAC, Erasmus Mundus website
Despite the massive growth in numbers of outgoing students, the number of students
returning to China grew even faster. For example, in 2004 25 000 students and
researchers returned from foreign countries. To increase the return rate of students,
government institutions
55
offer positions, funding and preferential tax treatment for
overseas talent to come back and work in China. The Ministry of Education is setting up
entire science parks and incubators where returned students and scholars are encouraged
to set up shop under very favourable conditions (NESO 2005).
While the growth rate of Chinese students going abroad has recently been slowing down,
doctoral S&E degrees earned by Chinese nationals at Chinese universities have grown
considerably and have since 1994 surpassed the number at US universities (NSF (2004)).
At the same time, more and more foreign students are coming to study in Chinese
universities, mostly from Asia (South Korea, Japan, and Taiwan) and Africa. In 2004
there were 110 000 foreign students in China. All this reflects the increasing
attractiveness of the Chinese Higher Education institutions.
2.6.4. China's S&T performance
The growth in R&D inputs (both funding and human capital) translates into a growth in
S&T output, as measured by publications and patents. With respect to scientific papers,
while China accounted for 1% of total SCI publications in 1991, it moved to 6.4% of
total SCI publications in 2004, occupying fifth place in the world, ahead of France and
Italy. There is however less growth in impact, as their share in citations indicates.

55
The Chinese National Natural Science Foundation offers research positions and funding for returning
junior faculty members. Also Chinese Science Academy`s One Hundred Talent Project provides
funding for overseas talent to come back and work in China.
35
01_2006_4142_txt_EN.indd 35 12-07-2007 10:43:18
Table 2-9: Publications and Citations by country
1991 2002 2004
Country Rank '04
Publications Citations Publications Citations Publications
USA 1 35.64% 53.61% 31.33% 47.33% 30.98%
Japan 2 7.64% 7.44% 9.21% 8.72% 8.67%
UK 3 8.59% 10.09% 8.69% 11.66% 8.43%
Germany 4 7.35% 7.81% 8.40% 10.53% 8.10%
PR China 5 1.22% 0.50% 4.88% 2.92% 6.41%
France 6 5.46% 5.91% 5.96% 6.81% 5.75%
Italy 7 3.07% 3.02% 4.29% 4.95% 4.48%
Canada 8 4.67% 5.00% 4.20% 5.19% 4.34%
Spain 9 1.75% 1.30% 3.15% 3.04% 3.26%
Russia 10 : : 3.20% 1.47% 2.88%
Source: SOO Statistics, KU Leuven
With respect to patents too, China has displayed strong growth performance, not only in
Chinese patents (SIPO), but also in Triadic patents. Nevertheless, although the growth is
strong, its position is still very modest; China accounting for only 1.4% of all world
patent applications. In 2003 China has 370 patents granted in USPTO compared to, for
instance, 35 500 for Japan. Furthermore, Chinese international patent applications are
dominated to a greater extent by foreign companies than in other countries. Between
1999 and 2001, almost half of all Chinese inventions were foreign owned, compared with
only around 10% for the US or EU-25.
Table 2-10: International Patent Applications (number and share)
1999 2004
China 277 0.36% 1708 1.4%
EPC 30557 40.0% 43909 35.9%
India 101 0.13% 724 0.59%
Japan 7473 9.8% 20186 16.5%
USA 31255 40.9% 43400 35.5%
Source: WIPO, 2005 (EPC= 30 European countries belonging to the European Patent Convention)
Overall, while the Western economies are still struggling with the consequences of
China`s entry into the world markets as a major supplier of labour-intensive products,
China has clearly embarked on a far more ambitious development trajectory of its own
S&T base. Although it is still at a low base, China has managed to put in a remarkable
growth performance in Science and Technology, supported by a targeted government
policy. Linking to international S&T, by attracting foreign R&D and by stimulating
international mobility of students, is seen as a key component of its strategy to further
develop its own indigenous S&T capacity. Opinions on the sustainability of its S&T
growth and capacity to acquire technological leadership are diverse. This will be further
examined in Part II.
36
01_2006_4142_txt_EN.indd 36 12-07-2007 10:43:18
2.7. Conclusion
China`s growth performance has been extraordinary since the start of economic reforms
and of the opening up process. The Chinese case provides persuasive evidence that
increasing openness to foreign trade and investment can lead to faster growth when
coupled with complementary reforms to enhance the domestic economy. As the Chinese
economy has gradually opened, it has become increasingly receptive to signals
emanating from the global economy.
56
It has gradually reorganised in such a way as to
bring its specific factor endowments into full play through a reform of its public sector
and a growing private sector. FDI inflows have supported the creation of new factories
and jobs, boosted export growth and led to important transfers of capital and
technologies. The importance of inward FDI for Chinese development is however
gradually declining as institutions improve, as the gap with foreign markets closes and in
response to the industrial policy choice of the Chinese government to rely more on local
firms and develop of indigenous know-how, at least in well targeted sectors.
Nevertheless, China is currently still relying to a large extent on wealth and knowledge
provided by partners in the world economy. The next chapter will therefore assess
China`s current position in the world economy and notably its influence on world trade
and investment patterns.
56
On the downside China has also become more sensitive to external shocks emanating from the world
economy. Today, the triad economies` business cycle development does have a distinct impact on
China`s economy. China remains, however, somewhat isolated from external shocks transmitted by
the forex markets. The Renminbi is still not convertible on the capital account and enables China to
isolate its fragile financial system from shocks like the Asian crisis¨.
37
01_2006_4142_txt_EN.indd 37 12-07-2007 10:43:18
Box 2-8: The globalisation experiences of China and India compared
China and India are often cited as two success stories of globalisation. Both have enjoyed rapid growth
alongside increasing integration into the global economy. However, their individual experiences have
differed greatly, with each exhibiting its own model of economic development. China has relied on FDI
and exports in manufacturing as a key anchor for its sustained acceleration in growth and integration.
Globalisation has benefited India most visibly by supporting the rapid development of the service sector,
which is now a key engine of growth in the Indian economy. If success is viewed in terms of accelerating
GDP growth, the growth of GDP per capita, an increasing share of global trade, and the magnitude of FDI
inflows, China would appear to have been more successful than India in all areas (see table).
The movement from autarky to international economic integration began in both countries following the
failure of self-sufficiency policies in the 1970s. Compared to China`s reforms outlined above, reforms in
India towards industrialisation were undertaken more gradually, and external liberalisation started later
than in China, triggered primarily by a balance of payments crisis in 1991. Prior to the crisis, India had
been reforming with a view to enhancing the competitiveness of domestic industry, while maintaining
protection against foreign competition. It has been asserted that pro-business reforms in the 1980s were
crucial to raising the profitability of domestic industry, setting the scene for pro-market reforms in the
1990s (Rodrik, Subramanian; Panagariya).
The slower global integration of India compared to China is often attributed to the government`s relative
tardiness in removing external barriers to trade and investment. In India, reforms were also geared towards
further opening the economy to trade and investment, including the dismantling of import controls,
reducing customs duties, abolishing licence controls on private investment, lowering tax rates, breaking up
public sector monopolies, and rupee devaluation. But only in the 1990s was tariff reform addressed more
systematically. The 1990s saw a compression of tariff rates, with the top rate falling from 355% in 1990 to
20% by 2004. India`s FDI regime has been gradually liberalised since 1991, and is no longer particularly
restrictive by international standards. Therefore, the cause for the underperformance of FDI in India
relative to China may not simply be rooted in FDI-specific policies, but rather in broader business climate
factors (IMF 2005c). The Global Competitiveness Report 2004 of the World Economic Forum suggests
that inadequate infrastructure, bureaucracy, corruption and restrictive labour regulations are among the key
constraints to doing business in India.
A key factor behind the different responses to globalisation has been the policies undertaken to promote the
manufacturing/service sector in each country, and the importance of investment in these sectors. China
implemented industrial reforms at a faster pace than India. In India, there has been a lack of systematic
reform in the agricultural sector, set against a slower pace of industrial reform. Industry remains
constrained, notably by inadequate infrastructure, high indirect tax rates, and labour market rigidities,
which deter job creation in the formal sector. Significantly slower industrial growth has reflected declining
investment, concentrated in manufacturing and agriculture. The investment decline is partly due to fiscal
crowding out, with large fiscal deficits for several years. On the other hand, the Indian service sector has
performed extremely well, in particular the business (including IT) and communication sectors. Factors
that could explain the relatively stronger performance of the services sector in India include: more
generous tax incentives relative to the industrial sector; the liberalisation of financial services; and reforms
in the 1990s, notably including the opening up of telecoms, which enabled a reduction in prices of telecom
services and supported increasing external demand for IT services. Labour restrictions and infrastructure
constraints may also have disadvantaged industry more than services. While India trails China in terms of
primary and secondary education, it has achieved better scores in higher education, resulting in a large
number of English-speaking highly-skilled graduates, something which has also supported growth in the
IT-sector.
38
01_2006_4142_txt_EN.indd 38 12-07-2007 10:43:19
China and India compared
1990 2003
India China India China
GDP growth (81-90; 91-2003) 5.8 9.3 5.6 9.7
GDP per capita, PPP, current USD 1380 1310 2670 4580
Share of world GDP (nominal) 1.4 1.7 1.6 3.9
Share of world trade (%) 0.6 1.7 0.9 5.6
Gross domestic savings (% GDP) 23.1 39.0 24.2 42.7
Gross domestic capital formation (% GDP) 26.3 34.7 23.3 44.4
FDI inflows (bn USD) 0.2 3.5 4.3 53.5
Share of agriculture (% GDP) 32 27 22 15
Share of industry (% GDP) 28 42 27 52
Share of services (% GDP) 41 31 51 33
Source: EC-DG Ecfin
39
01_2006_4142_txt_EN.indd 39 12-07-2007 10:43:19
3. CHINA`S POSITION IN THE WORLD ECONOMY
As China has gradually integrated the world economy, its economic weight has been felt
by other participants. China`s impact on the world economy has been accentuated due to
an increasing degree of openness to trade and FDI.
57
As a consequence, the volume of
Chinese exports of goods and services was exceeded only by the US and Germany,
despite these countries being much larger economies. Moreover, China is currently the
third largest importer in the world (ahead of France and the UK, but behind the US and
Germany).
Table 3-1 Share in World Merchandise Trade by Region, 2004
Source: World trade in 2004, WTO.
The position of China in world export markets is discussed in section 3.1, while the
impact of China on world imports and prices of intermediate goods is discussed in
section 3.3. With respect to FDI, the previous chapter already documented the
importance of China as a destination of FDI. However, as with indigenous industry
development, China is also increasingly a source of outward FDI and this will be
documented in section 3.2.
3.1. China`s position in Global Trade
China has become a major trading nation in the world economy. OECD estimates
suggest that by the beginning of 2010 Chinese exports may overtake those of the US and
may represent 10% of world trade at that point.
57
Trade amounted to 35% of China`s GDP in 2004.
Rank (USD billion) (%) Rank (USD billion) (%)
Germany 1 912.3 10.0 United

1 1525.5 16.1
United

2 818.8 8.9 Germany 2 716.9 7.6
China 3 593.3 6.5 China 3 561.2 5.9
Japan 4 565.8 6.2

4 465.5 4.9

5 448.7 4.9 United

5 463.5 4.9
Netherlands 6 358.2 3.9 Japan 6 454.5 4.8
Italy 7 349.2 3.8 Italy 7 351.0 3.7
United

8 346.9 3.8 Netherlands 8 319.3 3.4
Canada 9 316.5 3.5 Belgium 9 285.5 3.0
Belgium 10 306.5 3.3 Canada 10 279.8 2.9
Hong Kong, China 11 265.5 2.9 Hong Kong, China 11 272.9 2.9
Export Import
States
France
Kingdom
States
France
Kingdom
40
3. CHINA`S POSITION IN THE WORLD ECONOMY
As China has gradually integrated the world economy, its economic weight has been felt
by other participants. China`s impact on the world economy has been accentuated due to
an increasing degree of openness to trade and FDI.
57
As a consequence, the volume of
Chinese exports of goods and services was exceeded only by the US and Germany,
despite these countries being much larger economies. Moreover, China is currently the
third largest importer in the world (ahead of France and the UK, but behind the US and
Germany).
Table 3-1: Share in World Merchandise Trade by Region, 2004
Source: World trade in 2004, WTO.
The position of China in world export markets is discussed in section 3.1, while the
impact of China on world imports and prices of intermediate goods is discussed in
section 3.3. With respect to FDI, the previous chapter already documented the
importance of China as a destination of FDI. However, as with indigenous industry
development, China is also increasingly a source of outward FDI and this will be
documented in section 3.2.
3.1. China`s position in Global Trade
China has become a major trading nation in the world economy. OECD estimates
suggest that by the beginning of 2010 Chinese exports may overtake those of the US and
may represent 10% of world trade at that point.

57
Trade amounted to 35% of China`s GDP in 2004.
Rank (USD billion) (%) Rank (USD billion) (%)
Germany 1 912.3 10.0 United States 1 1525.
5
16.1
United States 2 818.8 8.9 Germany 2 716.9 7.6
China 3 593.3 6.5 China 3 561.2 5.9
Japan 4 565.8 6.2
France
4 465.5 4.9
France
5 448.7 4.9
United Kingdom
5 463.5 4.9
Netherlands 6 358.2 3.9 Japan 6 454.5 4.8
Italy 7 349.2 3.8 Italy 7 351.0 3.7
United
Kingdom
8 346.9 3.8 Netherlands 8 319.3 3.4
Canada 9 316.5 3.5 Belgium 9 285.5 3.0
Belgium 10 306.5 3.3 Canada 10 279.8 2.9
Hong Kong, China 11 265.5 2.9 Hong Kong, China 11 272.9 2.9
Export Import
01_2006_4142_txt_EN.indd 40 12-07-2007 10:43:19
Figure 3-1: World export market shares for different countries/country groupings
(manufacturing)
1992 1994 1996 1998 2000 2002
6
8
10
12
14
16
18
%Share of WorId Exports
South East Asia
EU15
1992 1994 1996 1998 2000 2002
0,4
2,4
4,4
6,4
8,4
10,4
%Share of WorId Exports
EU Neighbours
US
Japan
Americas
(excI. US)
China
EU10
India
Source: European Commission (2005b).
3.1.1. China's Trade by geographical area
Figure 3.2 details the geographical origin and destination of Chinese trade. Both on the
import and export side, the intra-South-East Asian regional dimension of China`s trade is
evident. South East Asia and Japan account for the majority of Chinese imports and
exports, an importance that continues over time (except for Japan). This intra-South-East
Asian trade is a reflection of the deep economic integration of the region (particularly
Taiwan, HK and PRC). In fact, a substantial share of trade within this region is intra-
company trade of multinational firms building their value added chain regionally.
Outside the South East Asian block, the US and the EU are important trading partners for
China. It is interesting to note that the EU has been outpacing the US as China`s major
trading partner (see Chapter 14 for more details on EU-China trade). Another point of
interest is the growth of trade with the rest of the world.
41
01_2006_4142_txt_EN.indd 41 12-07-2007 10:43:20
Figure 3-2: China`s World Market Share of Imports by Partner
0.5 0.5 0.4 0.4 0.4 0.4 0.5 0.5
0.6 0.6
0.7
0.3
0.3
0.3 0.3
0.3 0.3
0.3
0.3
0.4
0.4
0.5
0.7
0.6
0.6
0.6
0.5 0.5
0.6
0.6
0.7
0.9
1.0
0.7
0.7
0.6
0.7
0.7 0.7
0.8
0.9
1.0
1.2
1.5
0.8
0.7
0.7 0.7
0.7 0.7
0.8
1.1
1.2
1.6
1.9
0.0
1.0
2.0
3.0
4.0
5.0
6.0
7.0
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
row
SE_Asia excl China
Japan
USA
EU neighbours
EU25
China's WorId market share of import by partner
Source :
In %
China`s World Market Share for Exports by Partner
0.4 0.4 0.4 0.4 0.5
0.6 0.6
0.7
0.7
0.9
1.1
0.5 0.5 0.5 0.5
0.6
0.7
0.8
0.8
0.9
1.2
1.3
0.4
0.5 0.6 0.6
0.6
0.6
0.6
0.7
0.7
0.8
0.8
0.9
1.1
1.1
1.0
1.3
1.1
1.1
1.2
1.4
1.7
1.9
0.4
0.4
0.4
0.4
0.5 0.5
0.5
0.6
0.7
0.9
1.0
0.0
1.0
2.0
3.0
4.0
5.0
6.0
7.0
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
row
SE_Asia excl China
Japan
USA
EU neighbours
EU25
China's WorId market share for export by partner
In %
Source : EC Delegation on the basis of MOFCOM
The most recent data for 2005 show that the EU has become the first trading partner of
China, ahead of the US and Japan. Not insignificant shares are accounted for by Latin
America (4%) and Africa (3%). Nevertheless, the Asian region remains the most
dominant for Chinese trade.
42
01_2006_4142_txt_EN.indd 42 12-07-2007 10:43:20
Figure 3-3: China`s Top 10 Trading Partners 2005
(Share in total Chinese Trade (X+M))
Country Region
1. EU-25 15.3% 1. Asia 56%
2. US 14.9% 2. Europe 19%
3. Japan 13.0% 3. North America 16%
4. HK 9.4% 4. Latin America 4%
5. ASEAN 9.1% 5. Africa 3%
6. ROK 7.9% 6. Oceania 2%
7. Taiwan 6.4%
8. Russia 2.1%
9. Australia 1.9%
10. Canada 1.4%
Source: MOFCOM
Overall, China exports more than it imports, thus keeping a trade surplus. For instance,
in 2005 the trade surplus amounted to 7% of total trade flows. This surplus is first and
foremost with the US, but trade is also in surplus with the EU-25 and Hong Kong. China
runs a trade deficit with most other Asian countries (Taiwan, Korea, Asean10), and to a
lesser extent Japan. With Africa, Latin America and Oceania, there is a small trade
deficit. Overall, the major issue is the big and persistent trade surplus with the US, which
is very largely behiFnd the current tensions in Sino-US relations.
43
01_2006_4142_txt_EN.indd 43 12-07-2007 10:43:20
Figure 3-4: Trade Balance of China vis-à-vis trading partners (2005, bill USD)
-80.0
-60.0
-40.0
-20.0
0.0
20.0
40.0
60.0
80.0
100.0
120.0
140.0
Other Taiwan Korea ASEAN 10 Japan EU 25 Hong Kong USA World
in billion USD
Source: Customs General Administration of the People's Republic of China
3.1.2. China's comparative advantage in world markets
The reform process and rapid economic development have gone along with a sizeable
shift in China`s (Revealed) Comparative Advantages (RCA).
58
While resource-intensive,
low-tech and labour-intensive products lay at the heart of China`s export activities during
the 1980s, the country`s export structure had changed quite dramatically. The table below
sets out China`s RCA indices in global trade in 1995, 1998 and 2001 for those industries
with positive RCA in 2001. While labour-intensive products still command positive RCA
values, there are nonetheless positive and strongly increasing RCA values in some
medium-tech and more capital intensive products, most notably office machines and
automatic data processing machines (75) and telecommunication and sound recording
apparatus (76).
58
The Revealed Comparative Advantages (RCA) of a specific sector is measured by the ratio of the
export share of this specific sector to the export share for all products. An RCA value larger than 1
indicates that the country specialises in this sector, commanding a share in world export markets that is
higher than the country`s average share in world export markets.
44
01_2006_4142_txt_EN.indd 44 12-07-2007 10:43:20
Table 3-2: China`s Revealed Comparative Advantages in Global Trade, 1995, 1998,
2001
SITC-Classification / Product group 1995 1998 2001
85 Footwear 157.4 174.3 158.0
84 Articles of apparel & clothing accessories 162.4 165.0 145.8
83 Travel goods, handbags, etc. 153.1 170.3 142.0
32 Coal, coke and briquettes 75.6 73.9 113.1
81 Prefabricated buildings, sanitary, heating and lighting fixtures, n.e.s. 68.3 70.6 87.9
65 Textile yarn and related products 99.3 78.7 84.6
82 Furniture and parts thereof 39.0 45.8 62.4
52 Inorganic chemicals 85.6 78.4 58.5
76 Telecommunication and sound recording apparatus 25.9 28.2 51.5
75 Office machines and automatic data processing machines -43.1 13.4 49.9
69 Manufactures of metal, n.e.s. 31.5 39.7 48.2
88 Photo apparatus, optical goods, watches and clocks 20.2 31.3 1.8
Sectors with positive RCA values in 2001. Ranking according to 2001 RCA-values. Calculations based on OECD data.
Source: European Commission (2005a).
Exports of high-tech products grew rapidly, increasing their share of overall exports from
11% to 25% (1998-2003). At the same time, the Chinese economy is increasingly
importing high-tech products. Between 1998 and 2003, China`s imports of high-tech
products as a share of total imports increased from 21% to 29%. Within high-tech
sectors, China has been able to secure substantial shares in telecom and computers, two
of the fastest growing global export markets. Accordingly, China in 2004 overtook the
US to become the world`s leading exporter of ICT goods.
59
Figure 3-5: World export market shares for Telecommunication and Computers
Source: European Commission (2005b).
At the same time, China is shifting its import demand. While China previously relied on
electronic components, such as chips, imported from the US and the EU, these are now
increasingly being produced in China and/or sourced from other Asian countries. As a

59
China is the single largest exporter of ICT goods to the US, supplying 27% of US imports in 2004
(10% in 2000). OECD (2005)
199
2
199
4
199
6
199
8
200
0
200
2
0
5
1
0
1
5
2
0
2
5
3
0
% Share of WorId Export
Markets
EU1
5
China
South East Asia
TeIecommunications
199
2
199
4
199
6
199
8
200
0
200
2
0
5
1
0
1
5
2
0
2
5
3
0
% Share of WorId Export
Markets
Computers
EU1
5
China
South East Asia
South East Asia
Japan US
Japan
US
45
01_2006_4142_txt_EN.indd 45 12-07-2007 10:43:21
consequence, China runs a trade surplus in ICT with both the US and the EU and this
surplus continues to rise.
60
Since the latter half of the 1990s China has become the hub of electronics manufacturing
in the developing world and a key part of the value chain in many electronic products.
There are nevertheless marked differences across submarkets. The build-up of local
production facilities has been much faster in PCs and peripherals than in the field of
consumer electronics. This follows a typical pattern. Initially, resource-seeking FDI has
been highly welcomed in China, offering tax and other incentives, while market-seeking
FDI has been largely discouraged. Technology transfer from this FDI has been nurtured.
Gradually government and entrepreneurs have started to reduce the strong dependence on
foreign technology and have started to develop their own system technologies (for
example the mobile phone protocol TD-SCDMA and the EDS system for DVD
standard), which helped to protect domestic firms from foreign competition in the
Chinese market. Chinese firms in the electronics industry have considerably increased
their productivity and secured a large part of total manufacturing output. In this success,
government industrial policy has had a crucial impact, supporting domestic
manufacturing, offering tax and other incentives, and access to cheap loans, and pressing
forward Chinese standards.
61

60
OECD (2005)
61
Broadband Wireless is an area where the Chinese are at a disadvantage in that they have not yet
reached the level of design sophistication and component functionality of their foreign counterparts
such as Nokia. One area of broadband wireless that remains uncertain is the future of WiFi. In 2004
China declared its own WAPI standard to replace the WiFi for security reasons, but later withdrew its
plans. But the issue has come up again in 2006 (EC (Trade) 2006)).
46
01_2006_4142_txt_EN.indd 46 12-07-2007 10:43:21
Box 3-1: A computer ~Legend¨ in the making
Legend (rebranded in 2003 as Lenovo) is one of the biggest and earliest success stories of the Chinese IT
industry. It is one of the three biggest PC makers in the world, after taking over IBM`s PC business in
2004. In China it is the biggest seller of PCs, with more than a quarter of the Chinese market.
Legend was founded in 1984 by eleven scientists on Beijing campus. It started as a distributor of foreign
brands (IBM, HP etc), building up an elaborate distribution network in China. Although the company was
state-owned, it was structured from the start as a private company, with the founders managing to bring in
outside capital for the initial investment (RMB 200000 or $24000). It benefited early on from central
government`s desire to nurture a strong indigenous IT sector. Liu Chuanzhi (founder & chairman of the
Legend group, a computer engineer from the Chinese Academy of Sciences) obtained from the government
certain quite independent financial decision-making power and the power to set wages and bonuses for his
employees. However, when Legend wanted to make its own PCs, the government initially did not give
permission for production in China. So Legend first set up a factory in Hong Kong. But after its first
success, it soon obtained a licence and went back to China, where the first Legend branded PC rolled off
the production line in 1990. It also serves systems integration for large government clients.
In 1994 it listed its Hong Kong arm on the Hong Kong stock exchange. It currently has a Hong Kong and
New York listing. This has allowed the company to tap international investors to fund its growth, but also
to improve its corporate governance and transparency from (international) shareholder pressure. In
addition, it allowed the company to offer stock options to its employees, to tie their incentives closer to the
firm`s performance. Another big strength of the company over its mostly foreign rivals is the broader
access and deeper knowledge it has of the Chinese market. While foreign (US) companies do R&D mostly
with a view to global markets, Lenovo conducts R&D for the Chinese market, e.g. adapting keyboards
suited for Chinese characters and voice input and developing software for Chinese enterprises.
Source: On the basis of Mc Kinsey Quarterly and other news excerpts.
3.1.3. China's role in the international division of labour
62
To highlight the role which China plays in the international value added chain, this
section will look at China`s comparative advantages at the different stages of production
of traded goods. The table below gives a breakdown of Chinese exports and imports by
stage of production.
Table 3-3: Trade Pattern and Comparative Advantage by Stage of Production
% Break-down of
Imports*
% Break-down of
Exports*
Actual trade balance
(% of GDP)
1992 2003 1992 2003 1992 2003
Intermediate Goods 57.7 71.9 29.5 38.1 -5.1 -8.0
(Primary Goods) 8.1 11.8 7.6 2.6
(Parts and Components) 11.3 28.3 3.1 15.9
(Semi-Finished Goods) 38.7 31.9 18.3 19.6
Final Goods 23.9 25.3 46.5 60.8
(Consumption) 3.6 3.5 40.1 36.6 7.5 9.0
(Capital) 20.2 21.8 6.4 24.2 -2.6 1.0
Total 100.0 100.0 100.0 100.0
* Individual components do not add up to 100 since unclassified¨ goods are not included in the table.
Source: European Commission (2005b).

62
Based on European Commission (2004).
47
01_2006_4142_txt_EN.indd 47 12-07-2007 10:43:21
On the imports side, it shows a sharp increase in the share of intermediate goods in total
imports, with this increase being mainly driven by a more than doubling in the import
share of parts and components. This table clearly shows the rapidly changing structure of
Chinese trade, away from a model based on imports of raw materials and exports of final
goods to one based on specialisation in different stages of the production of specific
product groupings.
China`s comparative advantage lies in the downstream stages of production (i.e. final
goods), while the upstream stages (i.e. intermediate goods) displayi large structural
deficits. With China`s position changing in this way from comparative advantage to
disadvantage depending on the stage of production, vertical specialisation is a hallmark
of the Chinese development model. Within the international division of labour, China
specialises in the processing and assembly of a wide range of intermediate goods, most
notably parts and components and semi-finished goods, but also more recently a range of
basic materials. The large deficits in all areas of intermediate trade and surpluses in both
categories of final goods, i.e. consumption and capital goods, suggests China is still
mainly an assembly country on average, a position which is similar to a large number of
other low-wage South East Asian economies. But in terms of trend China`s future
position is very likely to shift away from its role as a pure assembly country. The
following graphs give a breakdown of how China`s trade has changed since the early
1990s by main trading partners as well as by nature of goods.
Figure 3-6: China`s overall trade in
intermediate goods by main trading partners
(Trade Balances as a % of GDP)
Figure 3-7: China`s overall trade in capital
goods by main trading partners
(Trade Balances as a % of GDP)
-7
-6
-5
-4
-3
-2
-1
0
1
EU 15 EU
neighbours
EU 10 Japan South East
Asia (excl
China)
USA World
%

o
f

G
D
P
Avg. 1992- 97 Avg. 1998-2003
-3
-2.5
-2
-1.5
-1
-0.5
0
0.5
1
EU 15 EU
neighbours
EU 10 Japan South East
Asia (excl
China)
USA World
%

o
f

G
D
P
Avg. 1992- 97 Avg. 1998-2003
Source: European Commission (2005b).
The graphs make a number of points. Firstly, while China has deficits in its trade in
intermediate goods with all areas of the world, in terms of parts and components and
semi-finished goods there is a relatively heavy concentration of such deficits with Japan
and other South East Asian countries. This pattern suggests that production sharing is
characterised by a strong regional dimension. Secondly, the recent shift towards
structural surpluses in capital goods suggests that China is beginning to move up the
value added chain. Such a move should be of concern to the TRIAD group since they
have traditionally had a comparative advantage in the production of such goods. The
strong surplus in it`s the EU`s trade with China in such products has been wiped out over
recent years. Japan`s surplus has been more than halved, and the US has gone from
- -
- -
48
01_2006_4142_txt_EN.indd 48 12-07-2007 10:43:22
surplus to deficit over the course of the period as a whole. This is a feature of a range of
US dominated high technology product areas, most notably in the ICT sector (cf above).
3.2. Outward-Bound FDI ~ One Step Further Towards Global Significance
In comparison to the huge flows of inward-bound FDI, outward-bound FDI originating in
China remains of minor magnitude. Nevertheless, the rising intensity of outward
investment activities by Chinese enterprises signals a new stage in China`s integration
into the global economy.
Outward-bound FDI still constitutes one of the most heavily regulated fields in the
Chinese economic system. Until the early 1990s, when foreign exchange was a scarce
and very precious resource, China`s FDI in- and outflows were greatly influenced by
political and macroeconomic considerations. The overall development strategy, as
devised by the economic bureaucracy in Beijing, still playis an important role with
respect to China`s outward FDI in the raw materials sector (cf above). Large purchases
of oil and gas sources have been made in Kazakhstan, Australia and Indonesia. But
today, it is increasingly the commercial and the strategic business development interests
of individual enterprises that drive China`s outward FDI activities. Outward FDI
provides a way for large Chinese companies to expand abroad and gain access to
distribution channels, trademarks and technology.
63
Starting from almost zero, China`s outward FDI has recently risen to considerable levels,
turning China into one of the most important developing country investors. The figures
presented here are, furthermore, likely to under-represent the true volume of Chinese
overseas investments, as FDI conducted by companies registered in Hong Kong and
other regions but controlled by mainland China is not included.
Table 3-4: China`s Outward-bound FDI Flows and FDI Stock, mio. US$
1990 1995 2000 2002 2003
Worldwide Total
(US$ bn) 1.03 1.89 3.73 9.34 11.42
%
EU-15 2.6 2.4 1.6 1.8 6
USA 28.1 18.7 13.6 8.9 8.3
Japan 0.7 0.8 0.5 0.9 0.8

SE Asia 17.4 18.4 22.7 56.2 52.6
Africa 4.9 6.5 17.6 8.8 8.1
Latin America 5.6 4.9 14.2 7 7.2
Source: Clegg (2005)
China`s outward FDI was during the early stages of development highly concentrated in
Hong Kong. Hong Kong functioned as a window to the world¨ for state-owned
enterprises, various branch ministries as well as local governments. They regarded Hong
Kong subsidiaries as vehicles for promoting the export economy of their home localities,
earning foreign exchange, accessing international capital markets, and providing training
possibilities for young managers (Taube, 1997).

63
Recent purchases include the computer manufacturer Lenovo`s purchase of IBM`s PC division, the TV
manufacturer TCL`s purchase of the French Thomson TV division, Shanghai Automotive acquiring
Korean Ssangyong, and Nanjing Automobilie`s acquisition of British MG Rover.
49
01_2006_4142_txt_EN.indd 49 12-07-2007 10:43:22
In recent years the geographical reach of outward FDI has increased substantially, as
China`s multinationals start to explore global markets. Between 1979 and 2002, about
60% of China`s cumulative investment value was directed towards Asia, followed by
North America, Africa, and Latin America.
64
Europe ranks fifth, with FDI inflows only a
fraction higher than those directed towards Oceania, and Germany, in 22
nd
place, is the
only European country listed in China`s top 30 FDI destinations.
The bulk of China`s outward FDI is still focused on trading activities, i.e. motivated by
the desire to promote China`s export industry. In addition to such market oriented
activities, Chinese enterprises are also making resource oriented investments in the
industrialised as well as in the developing world. The investments in the developed
countries are motivated by a desire to gain access to new technologies and know-how.
More recently, Chinese multinationals are beginning to invest with a view to establishing
their own brands in the Western markets, acquiring distribution networks as needed.
65
Securing natural resources for the further development of the Chinese economy lies at
the heart of a rising share of FDI directed at oil and natural gas, exploration and
exploitation projects, mining ventures, as well as other natural resource-based projects
predominantly in Central and South East Asia, but also in Africa and Latin America.
66
3.3. The impact of growing energy and raw materials demand in China
67
While China`s entry into world markets has provided global customers with cheaper
products, thus contributing to restricted levels of inflation in the West, China`s growth
has instigated concerns about the possible effect on energy and raw material supply and
prices. Chinese demand remains relatively low for its size (in terms of per capita
consumption levels), but is growing rapidly. Over the past decade, China has managed
to keep its energy growth rate well below its rate of GDP growth. However, a shift to
levels of consumption closer to the developed world could increase the impact of China
on global raw materials markets, depending on how Chinese demand evolves. IFRI
68
has
forecasted that Chinese energy consumption will overtake Western Europe`s by 2010 and
North America`s by 2020, with 20% of the increase in consumption coming from foreign
suppliers.
Fossil fuels are the major component of China`s energy demand. Coal still provides
about two thirds of China`s energy, while oil accounts for one quarter. Beijing would
like to shift China`s current energy mix more towards natural gas, renewable energy and
nuclear power. Beijing also intends to continue to improve energy efficiency and
promote the use of clean coal technology.
The table below gives an overview of developments in key energy sectors in the years
since 1997. In coal and gas, despite its high growth rates, China still only represents a
small fraction of world imports, as its growth is starting from such a low base. It will be
64
Data compiled by the Ministry of Commerce (MOFCOM), covering officially approved FDI only.
65
e.g. consumer goods maker Haier has succeeded in selling its own-brand fridges in Wal-Mart stores,
rather than rebranded ones.
66
MOFCOM, UNCTAD, 2003a
67
Based on a contribution by DG TRADE.
68
IFRI
50
01_2006_4142_txt_EN.indd 50 12-07-2007 10:43:22
some time before it becomes a really significant player, even if growth continues at
present rates.
But oil consumption has been growing particularly strongly, with imports covering
almost all of this growth.
69
Petroleum imports have been rising by an annual 13% over
the period 1997-2002. In 2004, China`s crude oil imports originated 45% from the
Middle East (of which 11% from Iran), 29% from Africa (of which Angola (13%), Sudan
(5%)), 9% Russia and 11% Asia Pacific. Net imports of oil are expected to rise further.
Table 3-5: China`s Trade in Energy
Commodity Chinese imports
2002 bn $
Av rate of
growth in %
(1997-2002)
Share of world
trade in %
(1997)
Share of world
trade in%
(2002)
Petroleum 17.4 13.2 2.8 4.2
Gas 1.6 12.7 1.5 2.1
Coal 0.3 28.7 0.4 1.5
Source: DG Trade.
In raw materials, demand is not equally important in all sectors and although growth
rates are high, demand often started from such a low base that China is still not a
significant importer. Over the period 1997-2002 China rapidly increased its iron and steel
consumption and is now the world`s largest steel consumer and a net importer. As
illustrated by the table below, China`s market share has increased in all sectors under
consideration - sometimes very significantly, like in iron ore and copper.
Table 3-6: China`s Trade in raw materials
Commodity Chinese imports
2002 bn $
Av rate of
growth in %
(1997-2002)
Share of world
trade in %
(1997)
Share of world
trade in%
(2002)
Iron Ore 2.8 11.4 12.7 22.9
Iron and steel 13.7 15.2 6.6 15.3
Base metal ores 2.3 16.2 5.4 12.3
Copper 4.4 21 7.2 22.4
Aluminium 2.1 12.2 3.5 6.2
Source: DG Trade.
High growth rates and rising importance in global terms inevitably mean that
developments on the Chinese market are having an ever stronger influence on world
prices of raw materials and energy. The suddenness of the change in certain sectors may
also imply that a smooth supply response cannot necessarily be assured. Nevertheless, at
this stage, it is impossible to make predictions about the impact of Chinese import
growth on prices. Much depends on the specific circumstances of the sector and the
elasticity of supply within it.
3.4. Conclusion
China has become an important player in the world economy. Total exports and import
volumes were exceeded only by the US and Germany. Most of China`s trade patterns
still reflect a specialisation in processing and assembling intermediate goods. This
processing trade is mostly a foreign firm activity, particularly from Japanese and other
69
DG RELEX, EU mission in China (2005)
51
01_2006_4142_txt_EN.indd 51 12-07-2007 10:43:22
South East Asian countries. Nevertheless, more recent trends suggest a move up the
value added chain, particularly in the ICT sector, where China has overtaken the US as
the largest exporter. Outward FDI is also rising slowly, albeit from very low levels.
Although the bulk of this outward FDI is still focused on trade activities and accessing
(natural) resources, Chinese firms are slowly beginning to invest abroad with a view to
accessing foreign markets. In line with China`s growth, its imports of energy and raw
materials have been growing and are predicted to continue to grow, with a likely impact
on energy prices.
China`s increasing weight in world trade yields a significant potential influence. The next
chapter will review how China`s foreign policy has evolved in order to handle that
influence, paying particular attention to relations with its Asian neighbours and its policy
as regards securing its energy needs.
52
01_2006_4142_txt_EN.indd 52 12-07-2007 10:43:23
4. CHINA`S EVOLVING FOREIGN POLICY
Over the last decade China`s foreign policy has become far more active. Its proclaimed
interest is to pursue an independent foreign policy of peace¨ in order to preserve
China`s independence, sovereignty and territorial integrity¨ and to create a favourable
international environment for China`s reform and modernisation.¨
70
China still faces enormous internal challenges and clearly needs a benign international
environment if it is to pursue its development and ensure a stable domestic environment.
China has engaged the international community, including Western democracies, to
foster its development, establish economic and cultural exchanges, and get access to the
most advanced technologies. In its attitude toward the international community China is
cautiously avoiding any confrontational approach.
China, a permanent member of the United Nations Security Council, has significantly
increased its participation in international organisations, especially - but not only -
financial ones. In particular, China has signed all international treaties related to non-
proliferation and joined most of the relevant international organisations, including in
1984 the International Atomic Energy Agency (IAEA). China officially stands for the
complete prohibition and thorough destruction of all kinds of weapons of mass
destruction (WMD), including nuclear, biological and chemical weapons.¨ China
acceded to the Treaty on the Non-Proliferation of Nuclear Weapons (NPT) in 1992, and
signed the Comprehensive-Nuclear-Test-Ban Treaty (CTBT) in 1996. However, China
believes that given the dual-use nature of various materials, equipment and technologies
in the nuclear, biological, chemical and aerospace fields, it is important that all countries,
in the course of implementing their non-proliferation policies, strike a proper balance
between non-proliferation and international cooperation for peaceful use of the relevant
technologies.¨
71
China is keen as well on maintaining harmonious relations with other countries in the
world¨ including forming a stable and healthy relationship with the United States,
instead of challenging or confronting the latter or replacing its role as a dominant
power.¨
72
China has also worked on enhancing its ties with Europe. In 1996 China
became a founding member of the Asia-Europe Meeting (ASEM), and in 2003 issued its
first-ever China`s EU Policy Paper¨, acknowledging that the EU is a major force in the
world¨ and that the Chinese Government appreciates the importance the EU and its
members attach to developing relations with China.¨
73
However, China stands firm on foreign demands and does not compromise on issues it
regards as national vital interests. On the basis of the Five Principles of Peaceful
Coexistence - mutual respect for sovereignty and territorial integrity, mutual non-
aggression, non-interference in each other`s internal affairs, equality and mutual benefit,
70
China`s Minister of Foreign Affairs Website - http://www.fmprc.gov.cn/eng/wjdt/
71
SIPRI: China: Basic stand on non-proliferation,
http://www.sipri.org/contents/expcon/chinonprolif.html/view?searchterm=china
72
Yang Yi, Director of the Institute for Strategic Studies, National Defence University of China, quoted
in China Adheres to Harmonious International Relations¨, Xinhua News Agency January 6, 2006
73
EU- China relation will be dealt with in Part III.
53
01_2006_4142_txt_EN.indd 53 12-07-2007 10:43:23
and peaceful coexistence
74
- China makes sure it is in a position to defend its national
interests without allowing unwelcome foreign intervention. In particular, China stands
firm on dissuading Taiwan from independence. Being acutely aware that struggles for
strategic resources and strategic dominance may well occur, it knows it needs to stand
ready to face them, including militarily.
Since the end of the Cold War China has pushed for a multipolar world in which the
United States could be counterbalanced by flexible coalitions involving at different times
Russia, Europe, India, Japan and the countries of the Association of Southeast Asian
Nations (Asean).
Over recent years, China`s most significant foreign policy development and success has
undoubtedly been its proactive regional posture in diplomatic, economic and security
areas. China is deeply involved both bilaterally and multilaterally in the Asia-Pacific
region, in particular in South-east Asia, and is building a position as a major regional
power in a part of the world which is also of great economic and security significance for
the United States. China`s regional diplomacy serves its fundamental national interest
(China regards the region as vital for its own growth and prosperity) and reflects its long-
term security concerns, especially vis-à-vis the United States.
Besides, China`s economic growth and development has exposed the country to two
main factors of vulnerability: an increased vulnerability to maritime threats with the
growing concentration of China`s key economic assets along its eastern and southern
coastline,
75
and an overall increased level of dependence on external markets, especially
for foreign energy resources. China is eager to diversify its sources of oil supply and to
go global¨. It has already extended its reach into Africa, the Middle East and Latin
America One specific aspect of China`s quest for energy, which is shaping its foreign
policy, could be of great concern for the international community and notably Europe.
China is not loath to deal with autocratic regimes and is notably keen on assisting the
development of some countries with no strings attached. This may well undermine
efforts by the international community to make government and business more
accountable and to address some of today`s global threats, e.g. weapons of mass
destruction, organised crime or failed states.
76
4.1. World views of China
China is generally viewed as playing a significantly more positive role in the world than
the United States. However, China`s ratings in world opinion have slipped somewhat
lately, notably in European countries. While there is relative comfort with China`s
growing economic power, this is not the case with its growing military power.
74
The Five Principles of Peaceful Coexistence were first set forth by Premier Zhou Enlai at the start of
the 1953-1954 negotiations between China and India on relations between the two countries over
Tibet. They have been widely accepted since then as norms for relations between countries and have
been enshrined in China`s Constitution.
75
China`s sense of vulnerability regarding its communication sea lanes has been encapsulated in what
Hu Jintao has described as the Malacca dilemma¨, i.e. 80% of China`s imports come through the tiny
strait, and any naval blockade can wreck the Chinese economy.
76
The European Security Strategy identifies five key threats: regional conflicts, failed states, terrorism,
weapons of mass destruction and organised crime.
54
01_2006_4142_txt_EN.indd 54 12-07-2007 10:43:23
A poll of 33 nations (including six EU Member States: France, Germany, Italy, Poland,
Spain and the United Kingdom) completed in January 2006 by GlobeScan and the
Program on International Policy Attitudes (PIPA) for the BBC World Service asked
respondents to evaluate whether certain countries were having a positive or negative
influence in the world.
77
China`s influence was rated positively by 20 out of 33 countries,
while ten gave it a negative rating. On average 45% gave China a positive rating and
27% a negative one. Worldwide, young people (18-29 years old) and those with medium
or high levels of education are more inclined to view China positively (with 58%, 51%
and 52% of positive views
respectively).
Looking at 20 countries polled at
the beginning of 2005 and then
again in 2006, in 12 of them
ratings of China went down, while
in two of them ratings improved.
On average, its positive rating
dropped by nine points. Negative
shifts have occurred in four out of
the six EU Member States polled.
Positive ratings dropped between
2005 and 2006 in France, Italy,
Great Britain and Germany. In
Finland, polled for the first time in
2006, a majority of 54% view
China negatively. Today only one
country - Spain - still has mainly a
positive view (45%).
Negative shifts also occurred in Canada, Russia and in Asia, most notably in South
Korea. In 2005 South Koreans had been divided on China (49% positive, 47% negative),
while currently a 58% majority views China negatively. Positive ratings have dropped as
well in India, the Philippines, Australia and Indonesia. However, in all of these cases a
majority are still positive.
A December 2004 GlobeScan poll of 22 countries found that attitudes toward China`s
growing economic power were on the whole rather positive, with an average of 49%
viewing it as a positive trend and 33% as a negative one.
78
Among the EU countries
polled, the fact that China is becoming more powerful economically was viewed mainly
positively in France (59% positive and 31% negative);
79
in the United Kingdom (53%
positive and 34% negative); and to a much lesser extent in Poland (39% positive and
32% negative). Germany was divided between a 42% mainly positive view and a 44%

77
http://www.worldpublicopinion.org/pipa/articles/home_page/190.php?nid=&id=&pnt=
190&lb=hmpg1
78
http://www.pipa.org/OnlineReports/China/China_Mar05_rpt.pdf
79
However, a 2005 16-Nation Pew Global Attitudes Survey¨ shows that when asked more specifically
if China`s economic growth is good for our country, only 37% of the respondents in France answer
positively (against 56% in the UK and 53% in Germany) - http://pewglobal.org/reports/display.php?
PageID=805
Source: GlobeScan and PIPA for the BBC, January 2006
55
01_2006_4142_txt_EN.indd 55 12-07-2007 10:43:23
Source: GlobeScan and PIPA for the BBC, December 2005
mainly negative one, while a negative
view prevailed in Italy (47% negative
and 41% positive) and Spain (47%
negative and 31% positive).
The prospect of China`s rising
economic might was viewed
positively in most Asian countries
including India (68%), Philippines
(63%), and South Korea (54%). Only
Japan was less definite (35%
positive, 23% negative and 34% not
taking a position). In the United
States views were evenly divided
(46% positive and 45% negative).
Interestingly enough, a positive view
was also found in countries such as
Mexico (54% and only 18%
negative), whose manufacturing
sectors face significant competition
with China.
Attitudes toward China becoming
more powerful militarily - with an
average of 59% viewing it as a
negative development and only 24%
as a positive one - do not correlate
with the views on China becoming
more powerful economically. Most citizens in the EU countries polled had a negative
view on China increasing its military power (Germany 87% negative¨, Spain 76%, Italy
74%, Great Britain 65%, Poland 65% and France 64%). Worldwide, the countries most
concerned about the potential growth of China`s military power are Germany (87%),
Australia (78%), Japan (78%), Spain (76%), the United States (75%) and Italy (74%).
The one country where a majority views China`s increased military power positively is
India (56% positive, 27% negative).
A 2005 16-Nations Pew Global Attitudes Survey¨
80
found that there is substantial
support in most countries for a military rival to challenge America`s global dominance¨.
However, the idea of China emerging as a potential military rival to the United States
drew a mixed reaction, in particular in Europe, with opposition ranging from 71% in the
UK, France and Russia to 82% in Germany.
4.2. China`s reassurance policy
China is very much aware of the concerns raised by its rapid development.
81
It is
obviously keen on reassuring the international community about its intentions and

80
Ibid.
81
The Vice-President of China Institute of International Relations, Ruan Zongze, notes that China`s rise
occurs in a very specific environment with no precedent in the history of other previous rising powers,
i.e. an environment characterised by the constraints both of globalisation and the international legal
framework that emerged after World War II. Ruan Zongze, What Are the Implications of China's
Peaceful Rise to the World. http://www.crf.cn/peacefulrise/ruanzongze2.htm
56
01_2006_4142_txt_EN.indd 56 12-07-2007 10:43:24
convincing it that its rise is a long-haul peaceful process based on a cooperative approach
which is respectful of the current international system and not out to challenge it.
In November 2003 the foreign policy strategist Zheng Bijian (who was Vice-President of
the Central Party School when Hu was the School`s President) coined the expression
peaceful rise¨, which was promptly seized upon in December 2003 both by President
Hu addressing an audience that included a number of Politburo Standing Committee
officials, and by Premier Wen in a speech at Harvard University. However, even though
the expression is still sometimes used in Western countries, it has outlived its shelf-life in
China. Many scholars opposed the very term rise¨, arguing that China was not going to
rise so fast. It was far too optimistic and risked masking the numerous economic and
social problems facing China and complicating its arduous transition toward a market
economy. Peaceful rise¨ has now been supplanted in the official foreign terminology by
to the return of peaceful development¨.
On 22 December 2005 the State Council published a White Paper on China`s peaceful
development road¨.
82
This document takes stock both of international concerns regarding
China`s rise and the internal tensions deriving from it. The main message of this White
Paper is that despite gigantic achievements, China still remains the largest developing
countries in the world, with a formidable task of development lying ahead¨ and for its
own sake to achieve such a task the country needs an internationally and internally stable
and peaceful environment.
The document reaffirms the fundamental basis of China`s cooperation with the outside
world, the United Nations Charter and, importantly, the Five Principles of Peaceful
Coexistence. These two pillars of China`s views of international relations imply, as the
document recalls, that from a Chinese perspective the internal affairs of a country
should be decided by its people, international affairs should be discussed and solved by
all countries on an equal footing, and developing countries ought to enjoy the equal
rights to participate in and make decisions on international affairs.¨
A week before the release of this White Paper, Zheng Bijian, now Chairman of the China
Reform Forum, explained that China`s peaceful development road meant that we strive
for a peaceful environment to develop ourselves while using our development to promote
and preserve world peace¨. On its road China has no intention¨ stressed Zheng to
challenge or subvert the existing international political and economic order.¨ The
objective, he said, is to seek peace outside China¨, harmony inside the country¨ and
peaceful settlement across the Taiwan Straits¨, in other words what has already been
labelled by some scholars as Hu Jintao`s theory of the three harmonies, he-ping, he-jie
and he-xie.
83
Any move by China to put an end to its peace and development line would signal a
fundamental policy shift. This could be of serious concern for the rest of the world. So
far the peace and development line has been seriously challenged only once under the
constraints both of globalisation and the international legal framework that emerged
after World War II. Ruan Zongze, What Are the Implications of China's Peaceful Rise to the
World. http://www.crf.cn/peacefulrise/ruanzongze2.htm
82
People`s Daily On-Line, December 22, 2005
83
Chairman Zheng Bijian, China Reform Forum, Ten Views on China's Development road of Peaceful
Rise and Sino-European Relations, The Foreign Policy Centre, London, December 15, 2005
57
01_2006_4142_txt_EN.indd 57 12-07-2007 10:43:24
1999 accidental bombing of the Chinese embassy in Belgrade during the NATO
operation.
4.3. The regional opening-up of China`s foreign policy
In the 1990s China launched its great regional diplomacy drive (da zhou bian wai jiao)
for amicable, secure and prosperous neighbourhood relations. The intention was in the
short term to secure China`s position at a time of international isolation subsequent to the
Tiananmen Square protests crackdown, and in the long term to consolidate China`s place
in the Asia-Pacific region, especially in South-east Asia.
Under the great regional diplomacy initiative, China worked on deepening ties with some
18 countries in the region.
84
China`s opening up to the international community was also
marked by the end of its sceptical stance towards regional and multilateral institutions
which were previously perceived as a constraint on China.
85
The current dominant trend
is to view those organisations as venues for China to pursue its economic interests,
expand its regional influence, address mutual security threats, and check the United
States regional interests.
Indeed China has founded, joined and upgraded its participation in a number of regional
fora, notably those in which the United States is not the hub. China has deepened it
participation in the Asia-Pacific Economic Cooperation (APEC) forum and hosted for
the first time ever an APEC Leaders` meeting in Shanghai in 2001.
4.3.1. Central Asia
Central Asia is the backyard of Russia, but China is making extremely aggressive
inroads¨ says Niklas Swanström of Sweden`s Uppsala University.
86
Actually Russia has
long historical political and cultural ties with this region rich in oil and gas, and where
China has a growing economic interest in maintaining a stable environment. The
Shanghai Cooperation Organisation (SCO) became a way of fostering China`s strategic
economic and security objectives in Central Asia while reassuring Russia, the other
prominent SCO member.
China led the efforts to establish in 2001 the SCO, which begun as the Shanghai Five in
1996 (China, Russia, Kazakhstan, Kyrgyzstan and Tajikistan. Uzbekistan was invited to

84
Notably China`s diplomatic relations were normalised with Laos and Vietnam, then Malaysia and
Cambodia, and diplomatic ties were established with Singapore, South Korea then Brunei. Moreover
China addressed and settled a number of territorial disputes with Laos, Russia, Vietnam, Kazakhstan,
Kyrgyzstan and Tajikistan; in each and every settlement China received 50% or less of the contested
territories. Some disputes remain unsettled, such as the one between China and India that led to the
1962 war, but tensions over this issue have significantly decreased. China and India have passed two
agreements that led to important troop reductions and confidence building measures. Many observers
consider that the Line of Actual Control¨ in the Himalayas is increasingly viewed as a mutually
acceptable border.
85
China has always been cautious to stress that its regional policy in particular and its view of
international relations in general are based on partnerships and not alliances. That is one way to
differentiate between China`s foreign policy approach and the American alliance-type relationship.
86
Niklas Swanström, director of the Contemporary Silk Road Studies Programme at Sweden's Uppsala
University, quoted by Benjamin Kang Lim and Chris Buckley, China, Russia, Central Asians plan
anti-terror drill - Washington Post, April 26, 2006
http://www.washingtonpost.com/wp-dyn/content/article/2006/04/26/AR2006042600271.html
58
01_2006_4142_txt_EN.indd 58 12-07-2007 10:43:24
join in 2001). The organisation`s role gradually moved from resolving border disputes to
fighting the three evils¨ of extremism, terrorism and separatism, and promoting greater
regional economic integration and development. Security is obviously a fundamental
concern. All SCO Member States face serious challenges from militant Islamist groups.
That may be a reason why unlike the West, China and Russia sympathise with the
problems that the region`s often harshly authoritarian states face with militants.¨
87
The
SCO members have created a Regional Antiterrorist Structure (RATS) and signed the
Shanghai Convention on Terrorism, Extremism and Separatism¨.
The SCO Member States cover an area that represents about three fifths of Eurasia, with
a population about a quarter of the world`s total. In 2004 Mongolia became the first
country to receive observer status; then Pakistan, India and Iran received observer status
at the 2005 SCO summit in Kazakhstan. Should those countries ever become full
members the SCO will then represent 40% of the world`s total population.
Furthermore the region`s important reserves of oil, gas and minerals, and its strategic
position are also of great interest for Europe, the United States and Japan. India is
interested as well in gaining access to Central Asia`s gas supplies and has stepped up its
activities in the region. Central Asia could therefore become the ground for sharper
rivalries between those different players.

87
Niklas Swanström, Op.cit.
59
01_2006_4142_txt_EN.indd 59 12-07-2007 10:43:24
Box 4-1: China Russia relations
China and Russia share a 4 300 km-long border and for many years have entertained mutual suspicion and
enmity. It seems that pragmatism is now prevailing in their relationship. Over recent years China and
Russia have settled their long-standing border disputes, which brought the two countries to the brink of war
in 1969, and have enhanced their co-operation in different areas of common interest.
In 2005 President Vladimir Putin and President Hu Jintao met four times within a year. In March 2006 on
the occasion of the official inauguration of China`s year of Russia, the two countries issued a joint
statement pledging to tighten their ties by furthering co-operation in politics, energy and regional affairs.
2007 will be Russia`s year of China.
„ Energy co-operation
With 13% of the world`s oil and 45% of its gas, Russia ranks among the top world producers and is an
essential energy partner for China. Unsurprisingly energy co-operation is high on the two countries`
agenda of issues of common concern. Russia currently meets 8% of China`s energy needs and the two
countries are engaged in discussions to expand their energy co-operation on a number of fronts. Should
China succeed in fostering its energy links with Russia it would decrease its vulnerability to maritime
threats for the transport of raw energy. However, in the past few years Russia has actively played its oil
card¨ between China and Japan. Furthermore during Putin`s visit to Beijing in March 2006 a series of
energy agreements was signed, covering notably the delivery of natural gas and crude oil, but fell short of
China`s expectations.
88
Notably, Russia made it clear that until a feasibility study had been completed there
would be no progress about a separate Siberian pipeline to deliver oil to North-eastern China, which is
viewed by China as vital to satisfying to its growing energy demands. Besides Russia does not want to be
only a raw energy supplier to China. In particular, Russia is keen on ensuring further Chinese contracts for
Russian reactors. Two Russian reactors are currently being built in China and one should be operational by
the end of 2006. This project is worth $3.2 billion. President Putin emphasised during a press conference
that co-operation in the energy sector is not limited to deliveries of raw energy [it] includes deliveries of
Russian energy equipment. This refers to nuclear energy and the fact that Russia will continue to
participate in establishing new nuclear energy capacities for China.¨
„ Economic co-operation
Sino-Russian economic relations developed slowly in the 1990s. By 2005. the bilateral trade volume had
reached nearly $30 billion, i.e. a 37% increase over 2004, and the two countries have pledged to double
that level at least by 2010. China is likely to become the second largest trading partner to Russia.
„ Military co-operation
Since the end of the Cold War China and Russia have renewed and further developed their bilateral
military trade relationship. Today China is by far the largest market for Russian arms. In fact, the PLA is
mainly based on Russian equipment and technologies. China notably relies on Russia for fighter aircraft,
submarines and air defence system. Russia has also transferred missile and nuclear technology to China. In
August 2005 the first-ever China-Russia bilateral military exercise, Peace mission 2005, conducted along
China's north-eastern coastline and involving 9 000 Russian and Chinese troops, was an opportunity for
Russia to sell more military hardware to China. It also signalled to the United States that they were not the
only security guarantor in the region.
„ Some convergent world views and interests
Some analysts consider that the 1999 Kosovo crisis acted as a catalyst for stronger Sino-Russian relations
and strengthened their shared concern for the emergence of a multipolar international order.
In July 2005 President Hu Jintao and President Putin signed a Joint Declaration on the International Order
in the 21st Century, calling for adherence by countries in the world to international law and to some key
principles, including mutual respect for each other`s sovereignty, mutual benefit and non-interference in
each other`s internal affairs, a major role for the UN, multilateralism, equal dialogue, development, and a
new security framework for the world.
On the specific issue of Iran, both China and Russia have strong commercial and strategic interests in Iran,
which has a SCO observer status, and both would like as well to preserve the existing non-proliferation
regime.

88
See Yu Bin, China's Year of Russia and the Gathering Nuclear Storm, A Quarterly E-Journal on East-
Asian Bilateral Relations. Volume 8, Number 1, First Quarter 2006 - Centre for Strategic and
International Studies (CSIS)
http://www.csis.org/images/stories/pacfor/0601qchina_rus.pdf
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4.3.2. South-east Asia
Since the 1997 Asian financial crisis and China`s decision to come to the rescue of the
affected countries by revaluing its currency to help stabilise the regional economic order,
the Association of South-east Asian Nations (Asean) has enhanced its relations with
China, Japan and South Korea (Asean + 3). China has increasingly become a pro-active
player with an ever higher profile in this regional forum. In 2003 China formally acceded
to Asean`s Treaty of Amity and Cooperation in South-east Asia (TAC), becoming the
first non-Asean nation to do so.
89
The emerging role of China in the region reflects its growing economic importance to the
region. Over this last decade China has been a significant trading partner and has
conducted a skilful diplomatic operation. China has increasingly invested in South-east
Asia and has augmented its aid and development assistance. China`s trade and
investments are fast becoming the engine of economic growth in South-east Asia (see
economic section) but not only that - Chinese culture too is spreading throughout the
region. China considers higher education as a paramount element of statecraft and is keen
on training future generations of intellectuals, technicians and political elites of the
region in its universities and colleges.
Asian countries for their part tend to view China`s rise as inevitable and obviously prefer
to see China engaged in as many ways as possible. A number of China`s neighbours
remain concerned about China`s real intentions and in particular about the development
of China`s power projection capabilities and the potential for the use of force against
Taiwan.
Some analysts suspect that China plans to become the predominant force in South-east
Asia by putting in place a grid of relationships that places Beijing in a position of
leadership and influence while isolating the United States from its traditional security
role and its allies in the region.
90
However, China is far from being the only major player
in the region and must share the regional stage with the United States, Japan and,
increasingly, India.
4.3.3. The limits of China's influence over Asia
4.3.3.1. A diverse region
Asia is a region marked by disparate geography, languages, political systems - from
democracies to authoritarian regimes - standards of living, and degrees of integration
with the outside world. Those factors are probably major obstacles to deep integration,
and they also play a role in the diverse regional perceptions of China`s economic rise.
Asean countries benefit differently from trade with China according to their respective
89
The Treaty of Amity and Cooperation dates back to 1976 and stipulates that relations between the
signatory countries should be based on the following fundamental principles: mutual respect for
independence, sovereignty, equality, territorial integrity, and national identity of all nations; the right
of every State to lead its national existence free from external interference, subversion or coercion;
non-interference in the internal affairs of one another; settlement of differences or disputes by peaceful
means; renunciation of the threat or use of force; and effective cooperation among themselves.
90
For example, according to Francis Fukuyama, the Chinese know what they are doing: over the long
run, they want to organize East Asia in a way that puts them in the centre of regional politics. They can
succeed where ¨then Malaysian Prime Minister] Mahatir failed because they are an economic
powerhouse capable of doling out favours.¨ Wall Street Journal, March 1, 2005
61
01_2006_4142_txt_EN.indd 61 12-07-2007 10:43:25
level of development. The less developed Asean countries will need some time to make
the necessary adjustments not to be overwhelmed by the Chinese, especially in the
labour-intensive industries. In some sectors, such as electronics, motorcycles, fruits and
vegetables, in which Chinese goods have begun to supplant those produced in South-east
Asia, China`s expansion is not welcome, and since January 2005, the surge in China`s
textile export has also generated stiff competition for countries such as Cambodia and
Vietnam.
4.3.3.2. An unstable region
North-east Asia is the theatre for two latent conflicts, the Taiwan Strait and the Korean
Peninsula. Taiwan remains a major security risk in the region, and a crucial factor in
Sino-U.S. relations. The anti-secession law passed by China in 2005 raised concern
around the world. Much attention has been paid to the bellicose language of Article 8,
that authorises the use of non-peaceful means should possibilities for a peaceful
reunification with Taiwan be completely exhausted. The European Union immediately
issued a statement expressing concern and urging all parties to avoid any unilateral
action which might rekindle tensions.¨ However, the Chinese side stressed that other
articles of the law should not be ignored, such as Articles 6 and 7, which lay out a series
of measures to maintain peace and stability in the Taiwan Strait and promote cross-strait
relations. They affirm that China stands for the achievement of peaceful reunification
through consultations and negotiations on an equal footing between the two sides of the
Taiwan Strait.¨ Indeed the Chinese leadership continues to signal its interest in
expanding cross-strait economic, tourism and cultural ties, a move backed by the
Taiwanese business community, including within the ruling Democratic Progressive
Party (DPP). 2005 began with the cross-strait flights on the occasion of the Chinese New
Year, the first such flights in 56 years. When the two sides agreed on these flights, China
had already announced its anti-secession law, which was subsequently adopted on 14
March 2005. The second round of direct New Year`s flights was conducted successfully
by both sides between 20 January and 15 February 2006 with an increased number of
flights and of cities served. Furthermore China is out to improve its contacts with
Taiwan`s main opposition parties (the Nationalist Kuomintang - KMT - and its junior
partner the People First Party -PFP) while deliberately avoiding contacts with
representatives of the Taiwanese government or the ruling DPP. This clearly means that
the Chinese leadership has no intention of doing business with the Taiwanese President
Chen Shui-bian during his remaining two years in office.
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Box 4-2: The Taiwan issue: Three different views on the status of Taiwan
ö The United States has basically developed a policy approach of strategic ambiguity¨ over the Taiwan
issue. The U.S. legal position from the 1950s on is that the status of Taiwan is undetermined. However, the
U.S. does not support formal independence. In 1979, the U.S. changed its diplomatic recognition from
Taipei to Beijing, recognising the Government of the PRC as the sole legal government of China and
acknowledging the Chinese position that there is but one China and Taiwan is part of China. As part of de-
recognition, the U.S. also notified the Taiwan authorities that as from 1 January 1980, it would terminate
the 1954 Mutual Defence Treaty. Subsequently, the U.S. affirmed its security and other interests in Taiwan
through the Taiwan Relations Act (TRA - 1979) and the continued supply of U.S. military equipment of a
defensive character to Taiwan. The TRA states in particular that the U.S. policy is to make clear that the
United States decision to establish diplomatic relations with the People's Republic of China rests upon the
expectation that the future of Taiwan will be determined by peaceful means¨; and to consider any effort to
determine the future of Taiwan by other than peaceful means, including by boycotts or embargoes, a threat
to the peace and security of the Western Pacific area and of grave concern to the United States.¨
ö The PRC position is that Taiwan was handed to China after World War II. The PRC bases its claim on
the 1943 Cairo declaration of the Three Powers - Great Britain, the United States and China - which
affirms that Japan shall be stripped of all the islands in the Pacific which she has seized or occupied since
the beginning of the first World War in 1914, and that all the territories Japan has stolen from the Chinese,
such as Manchuria, Formosa, and the Pescadores, shall be restored to the Republic of China.¨ China`s
explicit political aim remains re-unification even if it is not in a hurry to achieve it. It seems that the
Chinese leadership is currently relying more on China`s soft power¨ to achieve this goal while trying to
isolate Taiwan diplomatically (e.g. to prevent Taiwan from being part of or involved in international
organisations) and maintaining military deterrence.
ö Proponents of Taiwan Independence argue that the status of Taiwan is determined, Taiwan being an
independent, sovereign state. They claim that the Cairo declaration is a non-binding document as it remains
unsigned (it was released on 27 November 1943, albeit unsigned). Furthermore they stress that the Treaty
of San Francisco (1952), which formally declared the end of the war between Japan and each of the Allied
Powers, states that Japan renounces its ownership over a number of areas including Taiwan but does not
specifically state which nations are sovereign over these areas.
As for the Korean Peninsula, since the 1990s Beijing has engaged in a delicate balancing
act, courting ties with Seoul while remaining mindful of Pyongyang`s interests and
survival. (..)¨. These deft manoeuvres have raised China`s strategic profile over the
Peninsula, making Beijing an indispensable arbiter in any negotiations related to
unification to its own liking.¨
91
The South China Sea is of crucial importance for regional and international trade. It is a
zone rich in fisheries and above all expected to have oil and gas reserves. Moreover,
China views the South China Sea as an exclusively Chinese sea and claims nearly its
entire territory. The Parcel islands are also claimed by Taiwan and Vietnam, and the
Spratley islands are partially claimed by Brunei, Indonesia and the Philippines, and are
also fully claimed by Vietnam and Taiwan In this context, the build-up of China`s
southern fleet worries the other claimants, who are unable to organise themselves and to
reach some common position. The South China Sea is nothing but a source of disunity.
Asean has tried to address this problem. In 1992, the Asean Declaration on the South
China Sea was an attempt to promulgate a code of conduct based on self-restraint and
peaceful dispute resolution, but did not deal with the very issue of sovereignty. In 2002
China and Asean signed a Declaration on the Code of Conduct of Parties in the South
China Sea, but this is not a binding document. Up to now China has not possessed the

91
Toshi Yoshihara and James Holmes, Command of the Sea with Chinese Characteristics¸ Foreign
Policy Research Institute, Fall 2005
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01_2006_4142_txt_EN.indd 63 12-07-2007 10:43:25
necessary capabilities and power projection to impose its dominance in South China Sea.
However Western military analysts have noticed that the Chinese navy`s expansion
efforts have acquired significant momentum in the past few years. Since 2001 China has
produced 23 new amphibious assault ships and 13 conventional attack submarines.
92
It
seems that China`s fleet will remain eminently regional with power projection to protect
sea lanes of communication, to support claims over maritime disputed areas, to engage
the Taiwan fleet, and to complicate any American intervention in the East Asian littoral.
Furthermore China`s navy modernisation and reinforcement will probably alarm the
surrounding countries and other regional powers such as India and Australia and may
lead to a region-wide naval forces renewal.
93
A number of Asian powers are already
responding by developing military capabilities as a safeguard against China.
94
The East China Sea is also a zone rich in natural resources and at the heart of a long-
standing maritime dispute between China and Japan, which does not help to ease the
increasingly tense political relationship between the two countries.
4.3.3.3.China and Japan: a tense relationship
The relationship between China and Japan is under severe strain and can be summed up
as cold politics, hot economy.¨
95
For the seventh consecutive year, Japan`s trade with
China hit a record high in 2005, reaching $189 billion. Nevertheless the political
relations between the two nations, which are competing for regional leadership, have
steadily worsened and nationalism is high on both sides between a Japanese wounded
nationalism¨ and a Chinese assertive nationalism.¨
96
The two countries are at odds over
wartime history, maritime resources and territorial disputes.
Prime Minister Junichiro Koizumi`s repeated visits to the Yasukuni shrine since taking
office in 2001 have been strongly criticised by China and - combined with the massive
anti-Japanese demonstrations in major Chinese cities in the spring of 2005 - have
harmed bilateral ties. The Yasukuni shrine is dedicated to about 2.5 million people who
have died in Japan`s wars from 1853 to 1945, including since 1978 fourteen convicted
war criminals such as World War II Prime Minister Tojo Hideki. Beijing has refused to
meet with Prime Minister Koizumi over the Yasukuni issue. Premier Wen Jiabao
considers that the current tension does not lie with China, nor with the Japanese people,
but with the Japanese leader¨ and he believes that the smooth development¨ of relations
between the two countries would be difficult if the issue is not resolved.
97
The official
Japanese position is that it is erroneous¨ to view these visits as an attempt to glorify

92
Russia/China Convenient Allies, Oxford Analytica Brief, October 11, 2005
93
Guiseppe Anzera, The Modernization of the Chinese Navy, Power and Interest News report, 22
December 2005
94
Ralf Emmers, Maritime Dispute in the South China Sea and Diplomatic Status Quo, Institute of
Strategic Studies, Singapore, Working Papers 87, September 2005
95
Tomohoko Taniguchi, A Cold Peace. The Changing Security Equation in Northeast Asia, Orbis Vol.
49, Issue 3, Summer 2005
96
Byung-Joon Ahn, The Rise of China and The Future of East Asian Integration, Asia Pacific Review,
Vol.11, Issue 2, 2004
97
Premier Wen Jiabao`s press conference on 14 March 2006, the occasion of the closure of the National
People`s Congress, quoted by James J. Przystup, Looking Beyond Koizumi, Comparative Connections
- A Quarterly E-Journal on East-Asian Bilateral relations, April 2006 -
http://www.csis.org/images/stories/pacfor/0601qjapan_china.pdf
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Japan's past militarism. The Prime Minister has stated clearly that the purpose of his
visits to the shrine is to express respect and gratitude to the many people who lost their
lives in the war, that he does not visit for the sake of the Class-A war criminals, and that
Japan accepted the results of the International Military Tribunal for the Far East. He has
acknowledged that Japan, "through its colonial rule and aggression, caused tremendous
damage and suffering to the people of many countries, particularly to those of Asian
nations."
98
The Japanese leadership`s concerns regarding China`s military build-up and the maritime
disputes between Japan and China provide further grounds for growing tensions. The
2006 Diplomatic Blue Book issued by the Japanese Ministry of Foreign Affairs
emphasises the lack of transparency in China`s military budget. In December 2004 the
Japan National Defence Guidelines for the first time named China as a possible threat to
Japan`s national security and expressed strong concerns over China`s military
modernisation and the expansion of China`s area of operations at sea. A long simmering
maritime dispute opposes the two countries over the East China Sea, where their
respective exclusive economic zones overlap. This situation is potentially volatile.
Exploration of three natural gas fields and drilling rights are at stake. Japan and China
base their respective claims on two different international covenants. This makes the case
even more complicated.
99
Beijing and Tokyo keep holding a series of high level meetings
to address their dispute, but not much has been achieved so far. The question is whether
the two countries would be able to develop jointly the contested gas fields. The United
States takes no formal position over the East China Sea dispute, though it is obligated
under a security arrangement with Japan to defend Japanese forces should they come
under attack.
Furthermore Prime Minister Koizumi has taken steps toward cementing Japan`s alliance
with the United States, a move strongly supported by the Bush administration. Japan and
the United States have augmented their bilateral defence trade. The United States
supports constitutional reform that could allow Japan`s military to expand and be more
active in the region, and importantly for the first time ever, Japan and the United States
signed in February 2005 a joint statement that explicitly ties their bilateral alliance to
peace and security in the region. China regards the enhanced cooperation between Japan
and the United States as jeopardising its security interests and views Japan`s claim for
regional leadership as a throwback to imperialism.
As long as Koizumi is in office Japan-China relations are unlikely to improve, and China
is already looking at the post-Koizumi future. Koizumi`s tenure both as President of the
ruling Liberal Democratic Party (LDP) and Prime Minister end in September 2006.
However, from the Chinese perspective the end of the visits to the Yasukuni shrine will
remain the sine qua non condition for any improvement in the relationship. President Hu
gave that message clearly to a delegation of Japan-China friendship organisations led by
98
Ministry of Foreign Affairs of Japan - Basic Position of the Government of Japan regarding Prime
Minister Koizumi's Visits to Yasukuni Shrine (October 2005) -
http://www.mofa.go.jp/policy/postwar/yasukuni/position.html
99
Under the UN Convention on the Law of the Sea, an exclusive economic zone can extend up to 200
nautical miles from a country's shoreline. The East China Sea between China and Japan is only about
360 nautical miles at its widest. Japan considers on the basis of the UN Convention that the boundary
should be the median line between the two countries. China, which bases its claim on the 1958 Geneva
Convention of the Continental Shelf (i.e. coastal countries are allowed to extend their borders to the
edges of their undersea continental shelves) considers that its exclusive economic zone should extend
to the edge of its continental shelf, which would put the line almost up against Japan's shores.
65
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former Japanese Prime Minister Ryutaro Hashimoto, who visited Beijing in late March
2006 to exchange views on how to revive non-governmental contacts.
Some Japanese political figures and intellectuals have recently sent positive signals on
the Yasukuni issue and the need to improve relations between the two countries. The new
leader of the main opposition party, the Democratic Party of Japan, Ichiro Ozawa, has
been very critical of Prime Minister Koizumi`s China policy, including his controversial
visits to the Yasukuni shrine. Ozawa has also criticised his predecessor`s assertion that
China posed a military threat to Japan. Kanzaki Takenori, leader of the new Komeito
Party (NKP), i.e. the current LDP coalition partner, has expressed regret on several
occasions over Koizumi's Yasukuni visits - a source of tension in the coalition - and has
said recently that Koizumi`s successor must get down to the task of improving
deteriorating relations with China and South Korea.¨ Similar views have been expressed
by the chief editor of the Yomiuri Shimbun and the chairman of the Asahi Shimbun`s
editorial board in an unprecedented dialogue published in the February 2006 edition of
Ronza magazine.
100
Within the ruling LDP the two major contenders for the Premiership, Chief Cabinet
Secretary Shinzo Abe (by far the most popular potential contender, according to opinion
polls) and former Chief Cabinet Secretary Yasuo Fukuda, hold contrasting views on the
Yasukuni issue. Shinzo Abe, who is known for his nationalist sentiments, has defended
Koizumi`s Yasukuni visits - nevertheless, he has recently adopted a more careful
approach on this question - while Yasuo Fukuda has stepped up his rhetoric against
Koizumi's shrine and called in March 2006 for improved relations with China and South
Korea.
However, some observers wonder if the cessation of the visits to Yasukuni will actually
change anything. James Mulvenon, deputy director of the Centre for Intelligence
Research and Analysis in Washington, thinks that China has too long relied on Japan's
lack of historical veracity as a way to cover its own problems, and its own lack of an
affirmative strategy for getting along with Japan.¨ If Koizumi suddenly stopped visiting
the shrine, what would China do?¨ he asks. I'm not sure Beijing knows.¨
101
History may well continue for some time to get in the way of the Sino-Japanese
relationship, yet any further deterioration in their cold political relations could become
too much of a hindrance, not only for the two countries but for the whole Asia-Pacific
region. In May 2005 China`s Minister of Commerce Bo Xilai suggested a long-term
Sino-Japanese cooperation deal based on energy and the environment. If China and
Japan can do better in the area of energy and environmental cooperation, Sino-Japanese
relations will be pushed to a new platform¨, he said, drawing a comparison with the
European Coal and Steel Community centred on France and Germany.
102
4.3.3.4.China and India: the evolving relationship between two rising powers
China and India, the two oldest and still extant civilisations, are both developing very
quickly, albeit with different approaches related to their respective historical economic
100
James J. Przystup, op.cit.
101
Quoted by Robert Marquand, Gulf Widens between Japan. China, in The Christian Science Monitor,
April 11, 2006 - http://www.csmonitor.com/2006/0411/p01s03-woap.html
102
Weran Jiang, China looks beyond Koizumi in its Japan Diplomacy, China Brief, Volume VI, Issue 12,
June 7, 2006 - The Jamestown Foundation
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and political legacies. Actually India`s path of development is totally unique. India has
relied on its domestic market more than exports, consumption more than investment,
services more than industry, and high-tech more than low-skilled manufacturing.¨ Indeed
the contrast between India's entrepreneur-driven growth and China's state-centred model
is stark.¨
103
China and India have had a difficult past, but it seems that both nations have decided to
put it behind them. The turning point in Sino-Indian relations was marked by the then
Indian Prime Minister Rajiv Gandhi`s visit to Beijing in December 1988. On this
occasion the Chinese leader Deng Xiaoping declared that unless these two countries are
developed there will be no Asian century¨, and added that if China and India are
developed we can say that we have made our contribution to mankind.¨
During this visit India and China signed an agreement to set up a Joint Working Group to
defuse tensions along the border. More than fifteen years later, India still claims part of
Chinese-controlled northern Kashmir and the Askai Chin area, while China disputes
India`s control over its north-eastern state of Arunachal Pradesh. However, the trend is
definitely towards slow and pragmatic progress to reduce tensions between the two
countries. For example, while China continues its military and political support to
Pakistan, it also displays a more neutral stance on the Kashmir dispute between Pakistan
and India; which pleases Indian policy-makers.
Undoubtedly the continued growth enjoyed by both countries is a strong incentive for
China and India to move towards a more stable relationship and to develop a pragmatic
form of cooperation conducive to increased bilateral trade (where the potential is huge).
India accounts for nearly 80% of South Asian economic activity, and trade between
China and India has gone from $332 million in 1992 to $13.6 billion in 2005. Moreover
the two countries share the aspiration of a multipolar world which will take greater
account of their role. Both China and India are trying to position themselves not only as
major economic powers but also as major political powers in Asia.
The warming in China-India relations does not mean that it will be an easy partnership.
The two nations are competing in a number of areas, in particular in their simultaneous
quest for energy, a strategic priority for both India and China. The two nations are two of
the largest, fastest-growing energy consumers in the world. During his visit to Beijing in
January 2006 the Indian oil Minister, Mani Shankar Aiyer, signed an agreement to
cooperate with China in securing crude oil resources overseas and hence try to prevent
fierce competition for energy resources. However, before the ink was even dry on the
Beijing agreement, Indian oil ministry officials found out that Myanmar has agreed to
sell natural gas from a field partly owned by an Indian company exclusively to China.¨
104
China and India are also closely following each other`s naval ambitions. India is worried
about an increased China`s presence in the Bay of Bengal and in the Indian Ocean. For
both countries it is a vital national interest to modernise their naval forces for securing
shipping lanes and thereby ensuring that their respective energy supplies will not be
interrupted.
103
Gucharan Das, The India Model, Foreign Affairs, July/August 2006
104
Michael Vatikiotis, India and China. A Delicate Dance, International Herald Tribune, 24 January
2006
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India is pursuing a strategic partnership with the United States, which may sometimes
provoke tensions with China For example, the recent US-India nuclear deal on civil
nuclear cooperation was finalised during President Bush`s visit to New Delhi in March
2006 and was promptly harshly criticised by Beijing without waiting for Congress's final
decision on the future of a deal which is widely regarded as having been concluded in
great haste. As China in the past helped Pakistan to develop the missile technology that
enabled Islamabad to get its nuclear weapons, India is now worried that China`s reaction
may be a pledge to supply Pakistan with new nuclear technology.¨
105
Actually several
security experts consider that stepping up Indian production of fissile materials could
lead to increased tensions and destabilising arms competition in southern Asia, involving
India, Pakistan and China.¨
106
Finally, while Asia looks towards its leading powers, China, Japan and India, to promote
stability and prosperity in the region, the relationship between the three is far from
harmonious. For many observers Japan is trying to foster its ties with India to counter
what it sees as the growing strategic threat from China.
Still, whatever tensions persist in China-India relations it seems probable that their
parallel development will shift the global centre of gravity closer to Asia than any time
since the 18
th
century.¨
107
What is at stake with the improvement of China-India relations
is not only an enhanced economic development in the two countries but also, and as
importantly, economic development and stability in the broad region. Both countries
need each other to achieve those objectives and they would certainly prefer to maintain
their current modus vivendi. The Indian Foreign Secretary Shyam Saran recently declared
that India and China are too big to contain each other or be contained by any other
countries¨, and in this context both countries are shaping a strategic and cooperative
partnership for peace and prosperity.¨
4.3.3.5. The United States` and China`s influence in the region
Most observers agree that the most important relationship in the region with truly
regional and global implications is the Sino-American one. The United States has for a
long time been a dominant actor in the region, it has substantial economic interests and
numerous security commitments: five of the seven United States mutual defence
alliances are in Asia. The US-led regional security architecture remains the predominant
one. It is the so-called hub and spokes¨ system - the United States being the hub, and
Australia, Japan, South Korea, the Philippines and Thailand the spokes - which has
delivered stability and security to the region since the Cold War and has smoothed the
progress of Asia`s economic development.
Today a number of Asian nations complain that in the past few years the United States
has been excessively focused on terrorism and on bilateral relations as against the
multilateral relationship. As a result the United States` influence in the region is on the
decline. That is the case in South-east Asia, where the United States` influence is
105
Michael Vatikiotis, op.cit .
106
Testimony before the Senate Foreign Relations Committee, The U.S.-India Civil Nuclear Deal¨,
26 April 2006. A statement by Robert J. Einhorn, Senior Adviser, Centre for Strategic and
International Studies.
107
H.E. M.K Narayanan, National Security Adviser, India, China and India. the Asian Rising Powers
Debate. an Indian Perspective, The 3
rd
Global Strategic Review Conference of the International
Institute for Strategic Studies, Geneva, 18 September 2005
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01_2006_4142_txt_EN.indd 68 12-07-2007 10:43:27
decreasing while China`s is rising. In South Asia, both the United States` and China`s
influences are on the rise, and in Central Asia, the American presence has been
strengthened in the aftermath of September 11, while China`s influence is also on the
rise.
However, a number of regional players continue to welcome the United States` presence
including as a security guarantor. Besides, the United States remains an economic partner
of choice for the region and is not a threat to many manufacturers in Asia, while China is.
Furthermore, China`s lack of transparency in addressing transnational issues is a
continued source of concern among other regional players, with many seeing China as a
source of a number of non-military challenges such as environmental (for example 13%
of acid rain depositions in South Korea, 17% in Japan and 39% in Vietnam come from
China), or health problems (see the SARS crisis and its regional economic implications,
especially in the tourist industry).
Asian leaders are naturally reluctant to choose between China and the United States.
They are torn between their long term concerns over a bullying United States, a
hegemonic China and a resurgent Japan. (They) seem to be eager to maintain an identity
independent of Japan, China and the United States¨, and officials from Asean member
states indicate that Asean gives them the chance to talk on a more equal footing with the
potential hegemons.
108
4.3.3.6. The first East Asia Summit and the competition for regional leadership
The first East Asia Summit held in Kuala Lumpur in December 2005 perfectly mirrored
the complexity of a region that is undergoing profound changes. The United States did
not join the Summit. It refused to sign the Treaty of Amity and Cooperation (TAC), one
of the three conditions for participation in the Summit.
109
Chinese Premier Wen Jiabao explained at the 2004 Asean summit that China had
embraced Asean + 3 as a road towards the creation of an East Asia Community; a long-
term strategic choice in the interests of China`s development.¨ Obviously the way the
first East Asia Summit unfolded did not fit China`s preferred choice for a future East
Asia Community. The membership of the Summit (Asean + 3, Australia, New Zealand
and India) was the subject of disputes, notably over the participation of Western-oriented
countries. As originally conceived by Malaysia and supported by China, the East Asia
Summit was to include Asean countries plus China, Japan and South Korea (Asean + 3¨
format). Japan, joined by Indonesia and Singapore, led the fight to include Australia,
India and New Zealand. The participation of Australia and New Zealand in particular
was seen as ensuring that Asean would remain at the centre of any emerging East Asia
Community. Furthermore the Kuala Lumpur Declaration of 14 December 2005 made it
clear that future summits would be held only in Asean countries, while China had
suggested hosting the next meeting. As the chance of China leading an East Asia

108
Elizabeth Economy, China's Rise in Southeast Asia. Implications for Japan and the United States,
Japan Focus, October 10, 2005
109
For some analysts the American absence was short-sighted. Jusuf Wanandi, a scholar of the Centre for
Strategic and International Studies in Indonesia, expressed concerns about the lack of a United States`
policy on the region. I know about the mess in the Middle-East, but don`t be distracted¨, he says,
this is definitely whether you like it or not, the most important region for the future.¨ According to
him Asia needs the United States both as a balancing force and an economic power. In Seth Mydans,
Asian Leaders Search For Common Interests in America Absence, The New York Times, December
15, 2005
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Community some time in the near future waned, so China`s enthusiasm for the summit
cooled down.
An Eminent Person`s Group will work out an Asean Charter to be discussed at the next
Summit. They will undoubtedly have to balance the priorities of the more advanced and
the less advanced Asean members. However can an East Asian Community take off
effectively if Asia remains split, and China and Japan do not normalise their relationship?
After all, politics still takes precedence over economics, in Asia in particular.¨
110
4.4. China`s ~go global¨ energy policy
China`s limited progress in accessing local energy resources due to the maritime disputes
over the East China Sea and the South China Sea, and the growing instability in Central
Asia, have pushed the country to search for energy abroad in Africa, the Middle East and
Latin America. Between 2002 and 2004, 65% of the countries (excluding the United
States and Europe) visited by the top Chinese leadership were oil producers, and 72%
were exporters of oil and of important natural resources. The main driver here is
obviously economic. However, some aspects of China`s quest for energy resources raise
specific concerns. China`s pragmatic approach to international relations, based on the
principle of non-interference in domestic affairs, gives little room to other considerations
such as the political situation of the energy exporting country. This may have a potential
destabilising effect on regional security and may undermine China`s own efforts to be
seen as a responsible global power.
When courting energy exporters, China has a number of advantages: (i) China is not a
colonial power, (ii) China has not laid out a vision or a policy to transform some regions,
(iii) China is a huge market and magnet for investments, and (iv) China has been willing
to engage with those countries that the international community and in particular the
United States have sought to isolate.
4.4.1. Africa
China`s trade relations with Africa are growing fast, as Chapter 3 has shown. This is
mainly resource seeking. China now gets about 30% of its oil from Africa (mainly from
Sudan, Angola and Congo-Brazzaville). China has found in Africa a number of business
partners in countries where many Western nations have been reluctant to engage.
A 2006 White Paper outlines China`s policy objectives in Africa, stressing that the
relations - as are China`s relations with any other country - are based on the Five
Principles of Peaceful Coexistence and the One China policy. The document can be seen
as a response to criticism of neglecting political realities. It presents four general
principles and objectives of China`s African policy:
Sincerity. friendship and equality. China adheres to the Five Principles of
Peaceful Coexistence, respects African countries' independent choice of the road
of development, and supports their efforts to grow stronger through unity.
Mutual benefit. reciprocity and common prosperity. China supports African
countries' striving for economic development and nation building, is intent on
110
Eric Teo Chu Cheow, East Asia Summit. Big Power Rivalry But No Integration, The Nation,
December 14, 2005
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cooperation in various forms in economic and social development, and promotes
common prosperity of China and Africa.
Mutual support and close coordination. China will strengthen cooperation with
Africa in the United Nations and other multilateral systems by supporting each
other's just demands and reasonable propositions and continue to appeal to the
international community to give more attention to questions concerning peace and
development in Africa.
Learning from each other and seeking common development. China and Africa
will learn from and draw upon each other's experience in governance and
development, and strengthen exchange and cooperation in education, science,
culture and health. Supporting African countries' efforts to enhance capacity
building, China will work together with Africa in exploring ways towards
sustainable development.
China is an attractive partner for many African countries. A China Africa Cooperation
Forum was created in Beijing in 2000 to promote trade and investment with 44 African
countries. The forum provides a venue for Sino-African consultations and dialogue.
China`s non-interference in domestic affairs satisfies leaders whose countries are
characterised by poor governance and opaque political systems. Those leaders are ready
to give full support to China while they are reluctant to implement the kind of demanding
economic or political reforms required by the Western donors. That is the advantages of
the Beijing consensus¨ over the Washington consensus.¨
111
Political or economic
reforms are not seen as indispensable for long-term sustained development. China has
successfully exported its notion of economic development with Chinese characteristics,
encouraging its African trading partners to develop their economies through trade and
investment in infrastructure and social institutions, without dictating terms of political or
economic reforms.
112
This situation creates a collusion of interests that may hinder the proper functioning of
multilateral organisations. Ethiopia and Eritrea are voting members of the former United
Nations Commission on Human Rights - now the UN Human Rights Council - until
2006 and Sudan until 2007. In 2004 the United States and other Western countries were
blocked in their efforts to censure China for its human rights record, with Sudan,
Ethiopia and Eritrea all siding with China in the Commission. In the summer of 2004 the
then Chinese Deputy Foreign Minister Zhou Wenzhong said about Sudan that business
is business. We try to separate politics from business¨, adding that the internal situation
in the Sudan is an internal affair, and we are not in a position to impose upon them¨.
113
In
September 2004, China watered down a United Nations resolution condemning
Khartoum over the Darfur crisis. In November 2004 China signalled its opposition to the
111
Joshua Cooper Ramo cited by Drew Thompson, China's Soft Power in Africa. From the Beijing
Consensus to Health Diplomacy, China brief, The Jamestown Foundation, Vol. V, Issue 21, October
13, 2005
112
According to He Wenping, director of the African Studies Section at the Chinese Academy of Social
Sciences (CASS), China and Africa share the view that countries should not meddle in each other`s
affairs. 'We don`t believe that human rights should stand above sovereignty`, says He. 'We have a
different view on this, and African countries share our view.¨ See Paul Mooney, China`s African
Safari, Yale Global Online, 3 January 2005 - http://yaleglobal.yale.edu/article.print?id=5106
113
David Zweig and Bi Jianhai, China's Global Hunt for Energy. RealClear Politics, September 6, 2005.
http://www.realclearpolitics.com/Commentary/com-8_25_05_DZ_pf.html
71
01_2006_4142_txt_EN.indd 71 12-07-2007 10:43:28
United States` call to refer the issue of the Iranian nuclear programme to the United
Nations Security Council.
The greater danger is that China might trade certain weapons and technologies for access
to energy.
114
China is currently the world fifth largest arms supplier. China, which is now
Sudan`s main oil trading partner, has supplied Sudan with fighter aircraft and diverse
weaponry. China has also provided military training in Equatorial Guinea, and has been
involved as well in Ethiopia and Eritrea with military cooperation and arms sales, while
world leaders are worried about a new conflict in the region, with tensions rising along
the border between Ethiopia and Eritrea.
China-Zimbabwe military ties are among the closest on the African continent. In late
2004, President Mugabe ordered fighter jets from China (an order worth $200 million)
and a hundred military vehicles, a move that displeased South Africa. Many political
analysts fear that such transfers could spark an arms race in Southern Africa. In
December 2003, Premier Wen Jiabao declared that China respects and supports efforts
by Zimbabwe to bring about social justice through land reform¨; indeed, China has
secured the contracts to develop Zimbabwe`s agricultural, mineral and hydroelectric
resources. Zimbabwe`s vast mineral and precious metal deposits are fairly attractive to
China.
Beyond energy policy, trade relations and arms deals, the Sino-African relationship is
also an opportunity for China to boost its soft power. China is keen to promote China
studies and Chinese language training in Africa and seeks to establish Confucius
Institutes¨ in Africa programmes at leading local universities. Moreover African students
are welcome in China. In 2003, 1 793 African students studied in China, i.e. one third of
total foreign students that year. China plans to train some 10 000 Africans per year,
including many future African opinion leaders who once might have trained in the
West.¨
115
Box 4-3: China and the developing world
China`s track record on protracted high levels of economic growth makes it an interesting case study for
other developing countries. China itself regards its own development path as a model for other countries to
consider. China`s economic weight is also increasingly felt by other developing countries. Some countries
have been seriously squeezed, with China out-competing them not only on the export markets but also
competing with home-produced goods in domestic markets. Many have benefited handsomely, though, in
terms of China`s rapidly increasing imports. China has had a particularly voracious appetite for energy
sources. China`s quest to secure energy has highlighted how its actions may sometimes clash with
international norms.
China is increasingly contributing financial investments and aid to other developing countries. These
investments are often linked to its energy needs. When providing assistance, China does not base it on
conditionality. This is in line with China`s long-standing opposition to external interference in internal
affairs.
This has positive sides, as the receiving countries have wide discretion to use funding according to local
needs. Moreover, the investments funded by China may in theory improve the recipient country`s
economic wealth and growth potential. However, experience shows that aid and investments only

114
Information on arms sales to Africa comes from Joshua Eisenman, Zimbabwe. China's African Ally,
China Brief, Vol. V, Issue 15, July 5, 2005 - Ian Taylor, Beijing's Arms and oil Interests in Africa,
China Brief, Vol. V, Issue 21, October 2005 - David Shinn and Joshua Eisenman, Duelling Priorities
for Beijing in the Horn of Africa, China Brief, Vol. 5-21, October 13, 2005
115
Joshua Eisenman and Joshua Kurlantzick, China's Africa Strategy, Current History, May 2006,
pp.219-224
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01_2006_4142_txt_EN.indd 72 12-07-2007 10:43:28
contribute to long-term development if the political and economic institutional environment favours
development. Many of the countries where China is active (e.g. Zimbabwe, Sudan, Myanmar) have been
cut off from international assistance precisely due to deficiencies in this respect, be it due to a history of
corruption, bad governance or political oppression. Therefore, while China`s non-conditional development
aid may yield dividends in the short term, it may not be in China`s long-term interest as the funding may
undermine recipient countries` long-term development by handing a lifeline to regimes which are
otherwise cut off from international assistance.
International norms for development assistance exist. They are there for a reason: to ensure that
development assistance contributes to long-term development. By choosing to ignore the institutional
setting/internal political situation in the countries where China is present, China makes these international
norms less effective. More importantly from a Chinese perspective: while short-term interest in terms of
energy needs may well be met, by not considering the broader environment the long-term development of
the recipient countries may well be undermined.
4.4.2. Middle East
More than 45% of China`s oil imports were estimated to come from the region in 2004.
Iran alone already accounts for about 11%, and in October 2004 SINOPEC, China`s
second largest oil company, signed an oil and natural gas agreement with Tehran that
could be worth as much as $70 billion - China`s biggest energy deal yet with any major
OPEC producer.
116
Iran has obvious political and strategic advantages in cultivating
closer ties to China, as Tehran comes under increased international pressure over its
nuclear activities. The new Iranian President Ahmadinejad has spoken openly about the
imperative for Iran to forge strategic alliances with strong non-Western countries such as
China.
China attempts to improve its relations with its already established oil suppliers - Saudi
Arabia and Iran - by selling them military technology, and investing in their industries
and energy infrastructures. Furthermore China has also institutionalised its relations with
the Middle East through mechanisms such as the newly established China-Arab
Cooperation Forum.
4.4.3. Latin America
By making inroads in Latin America, China is entering the United States` traditional
sphere of influence. The United States is looking closely at China`s interference in a
region that has traditionally been within its sphere of influence and a major energy
supplier. Venezuela and Canada together provide the United States with a quarter of its
energy imports; Venezuela sells 60% of its crude oil to the United States and is the US`s
fourth largest oil supplier. For Latin America`s energy producers, China therefore offers
an opportunity to diversify exports.
The Sino-Latin American relationship is predominantly driven by economic interests.
Latin America`s share of Chinese imports grew from 2% in 1990 to 4% in 2004, and its
share of Chinese exports from 1% (1990) to 3% (2004), while China`s share of Latin
American exports are 6 to 10 % in 2003 up from 1 to 4% in 1999.
In Venezuela, for example, China has invested heavily in oil fields, gas projects and
upgrading the country`s rail and refinery infrastructure. China is also acquiring oil in
Brazil and Ecuador, and is investing in Argentina. China buys vast quantity of iron,
bauxite, soybeans, timber, zinc and manganese from Brazil, tin from Bolivia, and copper
from Chile.
116
David Zweig and Bi Jianhai, op.cit
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In November 2004, during his visit to Latin America, President Hu secured a market
economic status from Brazil, Argentina and Chile in exchange for pledging to invest
$100 million in Latin America for the next decade and reducing restrictions on Latin
American products entering the Chinese market. In January 2005, Chile and China began
discussions on an FTA. Brazil is also pushing for the creation of a FTA with China.
Overall, China may be benefiting from long-standing unease and increasingly critical
views on the level of US regional influence held by a number of administrations
currently in power (e.g. Hugo Chavez`s Venezuela, Fidel Castro`s Cuba, Nestor
Kirchner`s Argentina, Eva Morales` Bolivia and even Lula da Silva`s Brazil). However,
China remains very cautious about its involvement in this U.S. sphere of influence.
China`s involvement in Latin America is also a way of exerting some leverage on a
number of countries which have recognized Taiwan diplomatically (12 out of the 26
countries maintaining diplomatic ties with Taiwan are in Latin America).
4.5. Conclusion
China`s trading and diplomatic role in Asia is increasingly important, and regional
interdependence is probably conducive to a more stable environment. But it is too early
to say if China will become the Asian leading power. The United States remains an
important player in the region and is welcomed as such by a number of countries.
Furthermore China`s growing importance in the region is not free of risks, and the
neighbouring countries are directly exposed to the adverse consequences of China`s
economic rise, worsened by Chinese tendency to a lack of transparency. That means that
China`s neighbouring countries will be better off if China solves its own domestic
problems in an acceptable way and if they keep a balance to China`s rising power in the
region through their relations with the United States, and for South East Asia, through
Asean playing a more assertive role.
The relations between the Asian countries are based on the Five Principles for Peaceful
Coexistence, which include respect for sovereignty and territorial integrity. But the
region is very unstable, with hot spots such as Taiwan and maritime disputes over areas
rich in energy. In this context China`s military modernisation is of concern for its
neighbours and may lead to a potentially destabilising armament race.
China`s development and assistance policy towards a number of countries, especially in
Africa, may alleviate some of the problems encountered by those countries. But, as it
does not pay much attention to political reforms, it may also pose a risk of undermining
the capacity of the international community to influence countries in the direction of
good governance, human rights and political freedom.
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PART II: WHAT CHALLENGES IS CHINA FACING?
As the previous chapters have shown. the economic success of China's post-Maoist
development strategy is evident. For two and a half decades the Chinese economy has
been growing at truly remarkable rates and has now assumed an important position in
the world economy. In a number of sectors. China has caught up with the global
technology frontier and is now entering into a new phase of growth. relying more on
indigenous innovative capacity.
The remaining objectives. though. are daunting. Pulling all of China's population out of
poverty is an endeavour requiring sustained high growth for a long period of time.
Moreover. China's long-term growth strategy. as laid out in its 11
th
five-year Plan
(2006-2010). calls not only for more wealth. but for a ¨harmonious' society where
wealth is more evenly distributed and where growth is based on technology. economic
efficiency and low consumption of natural resources.
While growth remains high. are the foundations sufficiently sound to deliver this vision'
Despite the impressive scope of past reforms. challenges clearly remain. In order to meet
them. not only do the reforms agreed upon so far need to be implemented on the ground,
reforms also need to be broader and deeper. A number of areas warrant particular
attention in this respect and are elaborated upon in this part.
Securing a balanced macro-economic environment (chapter 5).
Upgrading the financial system (chapter 6).
Reforming the public and private production system (chapter 7).
Refocusing public finances (chapter 8).
Developing China's innovative potential (chapter 9).
Absorbing surplus labour (chapter 10).
Addressing the increase in inequality (chapter 11).
Addressing the environmental challenges (chapter 12).
Adapting China's political and legal system to a transformed society (chapter 13).
Overall. the biggest challenge for China is that the challenges cannot be tackled one-by-
one. Instead. they need to be dealt with together. failure to overcome the economic
challenges may increase the risks of internal political dissent, failure to overcome the
political and social challenges could have adverse economic consequences. Despite the
massive scope of the challenge ahead. but taking into account China's past determined
development path. it would be naïve to doubt that China will not be progressing towards
its targets and making the most of its strengths.
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5. SECURING A BALANCED MACRO-ECONOMIC ENVIRONMENT
The diverse forces that will impact on China`s economy as a result of trade and
investment liberalisation and the restructuring of the domestic economy will place heavy
demands on China`s macroeconomic policy instruments. As the earlier discussion
suggests, macroeconomic policy will need to be able to support higher real GDP growth
in order to create employment, without fuelling inflation.
Table 5-1: Macro-economic fundamentals in China
2003 2004 2005 2006
Real GDP growth 9.5 9.5 9.0 9.2
Inflation (CPI) 1.2 3.9 4.0 4.0
Fiscal balance (% GDP) -1.9 -0.9 -0.4 -0.2
Current account balance (US$bn) 45.9 68.7 100.0 101.0
Current account balance (% GDP) 3.1 4.0 5.2 4.6
Foreign exchange reserves (US$bn) 403.2 609.9 769.0 ..
Source: OECD (2005), ECB (2006).
A first macroeconomic policy area is improving the effectiveness of monetary policy in
managing aggregate demand. An important weakness - the poor financial conditions of
enterprises and of banks that are responsible for the present credit crunch - is likely to
take some time to remedy fully, as will be discussed below. However, interest rate
liberalisation is important too. Restrictions on bank loan rates limit the ability of central
bank operating instruments to control the effective cost of credit to final borrowers.
Interest rates in the inter-bank market have been freed, and in October 2004, the ceiling
of the floating bank rate band was abolished, enabling China`s banks to price credit risk
better. In practice however, banks have been slow to utilise fully their new autonomy,
stressing the complementarity with reforms in the financial sector (see Chapter 6).
A second objective is to accelerate the development of the government bond market in
order to accommodate the large increase in government debt that is likely to be needed
over the next few years (see Chapter 8). As the stock of debt grows, it will be
increasingly important to broaden access by domestic institutional investors and, at a
suitable point, to allow foreigners to purchase government bonds. Development of the
money market and liberalisation of bank loan rates is also important to bond market
development, to help securities dealers to fund inventories of government bonds.
The third challenge is to progressively increase the flexibility of the exchange rate and
capital control regimes. Ultimately, a floating exchange rate regime may well be best
suited to China`s conditions (see Box 5.1), in part because it will allow for more
independent monetary policy once the capital account is liberalised. Progressive
liberalisation of the capital account will be needed to allow domestic businesses
sufficient access to international financial markets as trade and investment liberalisation
progresses, and to help spur the development of domestic financial markets. Identifying
the steps needed to balance these considerations is very difficult. The risks of premature
liberalisation are especially great in China because of the poor financial conditions of
enterprises and financial institutions, weak corporate governance, and the incomplete
development of the financial supervisory and regulatory system, as will be detailed
below. In the short term, the stability afforded by the present exchange rate regime is
probably beneficial to China`s economy, but there is also a need to establish a foundation
for greater flexibility in the future.
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01_2006_4142_txt_EN.indd 76 12-07-2007 10:43:29
Box 5-1: What is the ~fair¨ value of the Renminbi?
China`s increasing bilateral trade balances with the triad economies and the fact that it is depreciating in
tandem with the US dollar against other currencies have sparked an intense discussion on the fair¨ value
of the Renminbi and its revaluation potential. Some observers claim that China clings to an undervalued
currency which provides it with unfair¨ advantages in global trade. While some authors see no case for a
revaluation at all (Bosworth, 2004), others see the Renminbi as undervalued by as much as 40% or even
more (Credit Suisse First Boston, 2003, Nomura Research Institute, 2003). The July 2005 revaluation of
the currency by 2.1% represents a small step in the direction of greater flexibility in the exchange rate. But
what is the fair¨ value of the Renminbi?
To begin with, the concept of a correct¨ and fair¨ exchange rate is highly complex. While several quite
diverse conceptual frameworks exist to evaluate equilibrium¨ exchange rates, no approach can claim to be
able to accurately pinpoint such a rate. Analyses based on the purchasing power parity (PPP) approach
attest the Renminbi to be undervalued. The United Nations` International Comparison Project even comes
to the conclusion that the equilibrium exchange rate for the Renminbi would be 1.74 RMB / 1.00 US$. In
order to reach this value the Renminbi would have to revalue considerably. This approach, however, is
based on absolute PPP and does not take into account the different levels of development of the economies
being compared. Adjusting for this effect, the Renminbi would be seen as undervalued (Nomura Research
Institute, 2003, Bosworth, 2004).
Very different conclusions can be drawn from analyses focusing on the economic fundamentals underlying
economic development in various countries. Most frequently employed by the IMF, this approach puts the
external balance (current account position) into perspective with the internal balance (medium-term saving
to investment position). Per Bosworth (2004) China does not have an undervalued currency according to
this methodology. In his analysis China`s present domestic saving-investment balance conforms with the
existing comparatively small current account surplus. The Renminbi should therefore be regarded as more
or less correctly valued. Given its high savings rate, any deviation from the status quo by revaluing the
Renminbi in order to attain a current account deficit, which is the standard recipe for developing
economies, is not viewed as a suitable policy for China.
An analysis based on the fundamental equilibrium exchange rate¨ (FEER) approach, which is closely
related to the IMF methodology, however, may indicate an undervaluation of the Renminbi. Williamson
(2003) argues for a revaluation of the Renminbi in a range of 20-30%. His assessment, however, is based
on the notion that China should strive for a current account deficit of about 1% of GDP.
A fourth approache is based on the notion that excessive¨ foreign exchange reserves are an indicator of an
undervalued currency. With its large and rapidly growing foreign exchange reserves China seems to be the
perfect revaluation candidate viewed from this methodological perspective. However, with an import cover
of 11-12 months, foreign exchange reserves are not excessive in an international perspective. Other Asian
economies like Japan and Taiwan feature import covers of up to 20 months.
Irrespective of whether the Renminbi should revalue or not, a comprehensive reorganisation of China`s
exchange rate regime can be expected. At the moment China operates a managed float system which in
practice, however, functions like a fixed peg. In the long term China has agreed to move to a floating
exchange rate system. This however seems to be far away and cannot be achieved before China`s financial
system has undergone a comprehensive restructuring and it appears safe¨ to introduce capital account
convertibility.
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01_2006_4142_txt_EN.indd 77 12-07-2007 10:43:29
6. UPGRADING THE FINANCIAL SYSTEM
A sound financial system is vital for the smooth functioning of an economy. A well
functioning financial system plays a crucial role in facilitating the allocation of resources.
The banking sector is the dominant intermediary of finance in China. Financial
intermediation in China is controlled by the state. The banking system is dominated by
the four State Owned Commercial Banks (SOCBs)
117
. Even though capital markets have
been growing rapidly in recent years, the equity and bond markets remain small.
Moreover, the financial system suffers from the virtual absence of institutional investors.
China is fortunate to have one of the highest savings rates in the world.
118
But the way
these savings are used leaves a lot to be desired. Banks have traditionally focused their
lending on large State Owned Enterprises (SOEs) and other players favoured by
industrial policy. While banks have been encouraged to spread their lending, many
private firms continue to suffer from inadequate access to finance. This lack of finance
for investments acts as a brake on Chinese private firms growing to a larger,
internationally competitive, scale (see Chapter 7).
Moreover, as SOEs have run into financial trouble, so has the banking system, which
explains why the reform of SOEs (see Chapter 7) and financial sector reforms are closely
linked. By the mid-1990s most of China`s banks were plagued by Non-Performing
Loans (NPLs) and as a consequence technically insolvent. Significant capital injections
and reforms to the way the banking sector operates have been undertaken or are under
way. Even though this has more or less restored the SOCBs to minimal levels of
solvency, the banking system overall remains in a precarious financial state.
At the root of many of the financial system`s current ills is that financial intermediation -
be it via banks or capital markets - has for long been subordinated to industrial policy
needs. The state`s influence remains pervasive. The government continues to use the
banking system to subsidise ailing SOEs and pursue special policy objectives which
continue to lead to non-performing loans. Even though reforms have been undertaken
and more are under way, the core challenge is to enable intermediaries to act
commercially.
Faced with these problems, Chinese authorities have invested significant energy in
upgrading the country's financial system. Apart from addressing the financial position of
the banking system, the authorities are trying to develop their capital markets by updating
regulatory structures and stimulating the development of supporting institutions.
However, more is needed to put the financial system on a sounder footing so that it can
be more effective in supporting growth.
6.1. Bank finance
The banking sector in China currently offers a mixed picture of modern elements mixed
with remnants from the time of central planning. It is dominated by four large state-
117
Bank of China, China Construction Bank, Industrial and Commercial Bank of China, Agricultural Bank
of China.
118
The high savings rate of the Chinese can to a large extent be attributed to precautionary savings for
health, pension and education, in view of the poor public provision.
78
01_2006_4142_txt_EN.indd 78 12-07-2007 10:43:30
owned commercial banks. These built up an impressive volume of non-performing loans
in the 1990s. The authorities have gone a long way to addressing the stock of these loans,
in the process restoring some of the leading banks to minimal levels of solvency. To
dilute the impact of NPLs in the current SOEs portfolio, the volume of new loans is
being stimulated. At the same time the governance of the SOEs needs to be improved to
decrease the risk of new bad loans being granted. Bringing strategic investors¨ and
foreign banks into the ownership of SOEs should introduce the necessary expertise,
capital and discipline to improve governance.
6.1.1. A large and growing banking system
As illustrated by the graph below, banks play a very dominant role in financial
intermediation. Credit provided by the banking sector amounted to nearly 170% of GDP
in 2004. This is more than in other emerging economies.
Figure 6-1: Domestic credit provided by banking sector (% of GDP, 2004)
0
20
40
60
80
100
120
140
160
180
R
u
s
s
i
a
A
r
g
e
n
t
i
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a
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B
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s
ia
H
o
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g
K
o
n
g
C
h
i
n
a
% GDP
Source: World Bank Development Indicators (2005).
Another characteristic of the Chinese banking system is the exceptional level of state
involvement. There has so far been very little privatisation, and the foreign presence also
remains limited. While China had one bank only prior to 1978, there are now four major
types of banks: (i) the State Owned Commercial Banks (SOCB), (ii) the Joint Stock
Banks (JSB), (iii) the Rural Commercial Banks (RCB) and (iv) the City Commercial
Banks (CCB). Despite this variety of banking institutions, the Chinese banking system is
very concentrated, with the four SOCBs accounting for the majority of credit
intermediation.
Bank lending has grown very fast in recent years. One reason is that as the Chinese
economy is growing rapidly, there is little alternative - domestically or, for that matter,
internationally - to bank financing for Chinese companies in need of capital. Moreover,
banks have recently started to move into new business lines as the Chinese economy
develops (e.g. home financing and consumer credit).
79
01_2006_4142_txt_EN.indd 79 12-07-2007 10:43:30
Banks have traditionally been government agencies and have played an important role as
vehicles of industrial policy. Up until the 1990s, they were particularly encouraged to
lend to State-Owned Enterprises (SOEs). However, during recent years there has been a
move towards market principles, with market liberalisation and opening and increasing
competition. The challenges that the banking system is facing are partly related to past
misdemeanours and partly to the need for further institutional changes to enable the
banking system to perform in a more market-driven environment. Even so, the build-up
of lending to the real estate sector in recent years is another example of how banks have
been used to support political objectives (in this case housing reform).
6.1.2. Addressing precarious financial positions
119
The past (and present) role of banks was (is) to act as a vehicle for industrial policy, i.e.
extend credit not on commercial but on political considerations. Banks were for a long
time encouraged to support SOEs. When these ran into problems in the 1990s, the
government encouraged further lending. The crisis duly spread to the banking sector,
leading to a build up of risky and
ultimately non-performing loans.
By the mid-1990s the banking sector
was basically insolvent, as Non-
Performing Loans (NPLs) greatly
exceeded equity. This was especially
the case for the SOCBs, where bad
loans according to unofficial estimates
exceeded 50% of outstanding loans.
While Joint-Stock Banks were less
exposed, City Commercial Banks and
especially Rural Commercial Banks
were seriously affected. Related to the
bad loans, Chinese banks also had low
levels of capital and little
provisioning.
The reasons for the bad financial
positions were partly beyond the
control of banks. Outside interference
by the government encouraged excessive lending to SOEs. Moreover, once in a situation
of having to argue for loans to be repaid, the banks were faced with limited legal means
to enforce loan agreements. However, the banks also helped to make the situation worse.
They had very weak internal loan assessment and risk management systems, poor
corporate governance and an antiquated loan classification system.
To correct this state of affairs, the Chinese authorities adopted a two-pronged approach.
A first wave of measures to address NPLs was started in 1998 with a capital injection
amounting to 3.5% of GDP. This was followed in 1999/2000 by a transfer of some NPLs
- amounting to 14% of GDP - to four bank asset management companies. A second, and
more comprehensive, wave of measures to address remaining NPLs was launched in
2003. That year, authorities injected a further US$45bn into two state-owned commercial
banks (BOC, CCB). This was followed in 2005 by a capital injection of US$15bn into
119
This section builds heavily on IMF (2004) and OECD (2005).
Non-Performing Loans of State Owned
Commercial Banks as share of total loans
31
26.1
20.4
15.6
10.1
0
5
10
15
20
25
30
35
2001 2002 2003 2004 2005Q3
% of total
loans
Source: China Banking Regulatory Commission and OECD (2005).
Note: figures for 2001 and 2002 follow old classification, 2003 and
forward follow new five part classification.
80
01_2006_4142_txt_EN.indd 80 12-07-2007 10:43:30
ICBC. Apart from more capital, banks have been allowed to set interest rates more freely
- and hence price risk more accurately. In addition, the heavily taxed banks have seen
their tax burden scaled down somewhat, as the business tax on gross income (on top of
the 33% corporate income tax) has decreased from 8% to 5%. As a result of these
reforms and increases in lending (which ceteris paribus decreases the NPL share of total
loans), NPLs have decreased substantially. However, the profitability of banks, though
positive, remains low by international standards.
Table 6-1: Profitability of Chinese and international banks (end 2003)
Bank Total assets
(US$bn)
Return on assets
(%)
BIS capital ratio NPL/total loans
(%)
Bank of China 464 0.3 7.0 16.3
Industrial and Commercial Bank 638 0.1 5.5 21.2
China Construction Bank 429 0.0 6.5 9.1
Agricultural Bank of China 360 0.1 .. 30.1
Bank of Communications 115 0.0 7.4 13.3
HSBC (Hong Kong) 277 1.6 12.1 2.3
Citigroup (US) 1264 2.1 12.0 2.7
JP Morgan Chase and Co (US) 771 1.3 11.8 1.5
Mizuho Financial Group (JP) 1285 0.7 11.4 4.8
Mitsubishi Tokyo Financial Group (JP) 975 0.9 13.0 3.1
Source: The Banker, as quoted in OECD (2005).
Moreover, it is far from certain that NPLs have been mastered. First, there is the
outstanding stock of loans that were approved up to the last batch of reforms. It is
uncertain how much of this lending might turn into bad loans, depending on the SOEs
reform process. Moreover, there is the issue of ongoing lending. China is currently in the
middle of a credit boom, with lending growing rapidly, notably for real estate. The
fundamental problems behind the past emergence of NPLs - i.e. the lack of a commercial
culture and safeguards against political interference - are not in place or sufficiently
consolidated to ensure that current loans are being properly allocated.
120
McKinsey
estimates that the banking system can only deliver 5-7% of safe¨ credit growth.
However, according to McKinsey the economy requires a 15% increase in credit to
deliver economic growth of 7-8%.
121
In addition, there are NPLs in other segments of the banking industry, notably rural
banks, where bad loans are estimated to amount to 23% of outstanding loans. Addressing
these effectively is made difficult by a lack of resources at sub-national level, among
other things. In addition, the asset management companies have had a very slow recovery
rate of NPLs and it is uncertain how much of these will turn into non-performing assets.
Finally, there are the remaining NPLs within SOCBs. These are difficult to address
without changes to the bankruptcy proceedings or the opportunity to sell to outside
investors.
Over and above the bad loans issue, there are the related challenges of insufficient capital
and lack of provisioning:
120
A recent episode illustrates the hazards of measuring how much of ongoing lending may turn sour. In a
report released in May 2006 and subsequently withdrawn, Ernst & Young, the auditing and consulting
firm, tried to estimate new bad loans resulting from lending between 2002 and 2004. Their estimate -
$911bn of total NPLs, $358 for the big four banks - was several times higher than the official
estimates referred to above. While Ernst & Young subsequently claimed these figures as factually
erroneous¨, the exercise nevertheless highlights the risks associated with ongoing lending.
121
McKinsey Global Institute (2005).
81
01_2006_4142_txt_EN.indd 81 12-07-2007 10:43:31
As illustrated by the tables above, capital adequacy ratios are very low, especially as
official figures are likely to overstate capital. Many emerging economies aim to have
ratios in excess of 10% to cover against risk. In China, capital adequacy ratios barely
reach 7%, as compared to the current minimum of 8% stipulated by the Basel
agreement and Chinese law.
Moreover, there is little provisioning against bad loans. This is compounded by a tax
system that does not allow provisions to be deducted from taxable income. All in all,
a significant addition of provisions is needed to cover for upcoming problems.
In sum, while the banking system does not present any immediate risk for the state`s
fiscal solvency, sizeable solvency problems remain. The banks therefore really must
ensure that current and future lending does not lead to new bad loans. This requires more
far-reaching changes.
6.1.3. Consolidating a commercial culture
122
The banking sector needs to be diversified if not only SOEs but also private investors in
general and SMEs in particular are to have adequate access to credit. This can be
achieved by building on the Joint Stock Banks and the City Commercial Banks.
However, the imminent dismantling of barriers to foreign entry will not be an immediate
panacea, due to problems which go deeper than market access.
Overall, banks need to improve their risk management skills. A modern banking industry
needs a strong credit risk management culture. Banks need to develop an ability to assess
and price risk. Corporate governance is a first safeguard. It provides for accountability,
which strengthens the ability to resist attempts at government interference in credit
decisions. Financial transparency has to increase to ensure that financial positions are
fully recognised. Moreover, more attention has to be devoted to compliance by regulators
and supervisors.
If they are to develop SME financing, banks need to be able to price loans more freely.
SMEs are associated with more risks, as they are small and often subject to more volatile
earnings. To cover against these risks properly requires further interest rate liberalisation.
However, irrespective of such liberalisation, the banks themselves need to develop the
ability to assess these risks.
6.1.4. Foreign presence
Since China became a WTO member in December 2001, it has gradually opened up its
market to foreign banks. At the end of 2005, foreign banks face geographical limitations
on where they can do local currency business and face limits on the stakes they can take
in Chinese banks (<25%). However, by December 2006 - five years after accession - all
barriers and exemptions will be dismantled and foreign banks will have full access to
China`s retail and wholesale banking business.
With respect to market size, foreign investors expect huge opportunities (estimates are
around 10% growth of the financial sector per annum until 2010)
123
. Foreign investors
are particularly looking to larger market opportunities in corporate banking and in trade
financing, following increased trading activity on the part of their home country
customers. Nevertheless, foreign banks have been cautious to enter the market despite
122
This section builds heavily on OECD (2005) and IMF (2004).
123
EC (Trade), EU Trade and Investment with China: changes, challenges and choices, 2006.
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01_2006_4142_txt_EN.indd 82 12-07-2007 10:43:31
greater ease of access since 2001. For example, foreign banks` share of the loan market
has not increased. Despite a handful of high-profile investments, overall foreign
ownership currently amounts to only 2%. This is related to remaining investment
obstacles. Establishing branches remains a difficult process for foreign banks.
Consecutive branch opening is restricted to one per year. In addition, there are
excessively high capital, liquidity and performance requirements for foreign firms
wanting to establish branches, similar to those for an additional full bank licence.
Furthermore, restrictive licensing rules remain in place for foreign firms` engagement in
RMB business.
124
Figure 6-2: Foreign banks` share of the banking market (2003)
0
10
20
30
40
50
60
70
80
China¹ Korea² Russia Thailand Mexico² Brazil Malaysia Hong
Kong
Czech
Republic²
Poland²
%
¹ 2004; ² 2001.
Source: OECD (2005).
Even so, foreign banks are present, with a number of foreign banks acquiring
shareholdings in China`s joint stock and city commercial banks. For example, HSBC has
acquired nearly one fifth of shares in Bank of Communications, China`s fifth largest
bank. In mid-2005 the Royal Bank of Scotland acquired nearly 10% of shares in Bank of
China, China`s second largest bank, while in October 2005 Deutsche Bank acquired
9.9% of shares in Hu-Xia Bank, the largest of China`s joint stock banks.
The Chinese authorities are also actively coveting international capital, e.g. by allowing
some banks to list on a securities exchange. Bank of China, China Construction Bank
and Industrial and Commercial Bank of China, for instance, are quoted on the Hong
Kong stock exchange.
124
EC (Trade), EU Trade and Investment with China: changes, challenges and choices, 2006.
83
01_2006_4142_txt_EN.indd 83 12-07-2007 10:43:31
Table 6-2: Foreign investment in China`s banks
Target Acquirers Share
DeaI vaIue
(US$)
Month
announced
Beijing Securities UBS 20% 210m Sep-05
Industrial & Commercial Bank
of China Goldman Sachs 10% 3.0bn Aug-05
Allianz
American Express
Bank of China Royal Bank of Scotland 10% 3.1bn Aug-05
Merrill Lynch
Li Ka-shing Foundation
Temasek 10% 3.6bn
China Construction Bank Bank of America 9% 2.5bn Jun-05
Temasek 5% 1.5bn
Hangzhou City Commercial
Bank
Commonwealth Bank of
Australia 19.90% 78m Apr-05
Bank of Beijing ING Group NV 19.90% 215m Mar-05
Shenzhen Development Bank Newbridge Capital Group 18% 145m Dec-04
Bank of Communication HSBC 19.90% 2.1bn Aug-04
Xing Ye Bank Hong Kong Heng Sheng Bank 15.98% 200m Jan-04
Singapore Government
Investment Company 5% 65m
International Finance
Corporation 4% 50m
Shanghai Pudong Development
Bank Citigroup 5% 70m Jan-03
Shanhai Bank HSBC 8% 60m Dec-01
Shanghai
Shanghai Commercial Bank
(Hong Kong) 3% 20m
International Finance
Corporation 7% 50m
Everbright Bank Asia Development Bank 1.90% 20m Dec-96
Source: Lehman Brothers, CBRC and China's commercial banks as quoted in Lehman Brothers (2005).
Nevertheless, in spite of the market opportunities and WTO commitments, foreign banks
may find it difficult to make sizeable inroads into domestic business, not only due to
restrictions on majority shareholdings and remaining market access impediments, but
also in view of the close links between domestic banks and firms, the extensive
established local networks, and the rapid catching-up in banking technology by domestic
firms. They may also hesitate in view of the significant residual uncertainty, notably
related to legal framework, government bail-outs and corporate governance provisions.
125
6.2. Capital markets
Capital markets play an important economic role. They offer financing to companies,
thereby reducing the exposure of the banking sector to commercial risks. They facilitate
company restructuring and changes of ownership and exercise an important disciplining
function on company managers.
126
Capital markets could play a particularly important

125
EC (Trade), EU Trade and Investment with China: changes, challenges and choices, 2006.
126
Newton and Subbaraman (2002).
84
01_2006_4142_txt_EN.indd 84 12-07-2007 10:43:32
role in China. They would help improve corporate governance in Chinese companies,
facilitate the sale of state assets and, as China is rapidly ageing, provide important high-
yielding saving instruments to Chinese households.
127
However, in spite of this central importance, China`s capital markets remain limited in
size, especially when compared to other emerging markets. True, from this small base
they are growing fast, as evidenced by the rapid rise of China`s equity markets. Even so,
behind these nominal growth numbers, markets remain hampered by government
imposed obstacles. Hence, their real economic size and importance remain limited. While
similar problems can be found in many transition economies - with the traditional
problems of weak rule of law and limited administrative capacity - they are here
compounded by the fact that capital markets are not subordinated to industrial policy.
The resulting mix of commercial and non-commercial logic means that they fail to
function effectively, and the resulting uncertainty tends to deter foreign institutions and
investors.
6.2.1. Equity markets
China has put in place the key structures underpinning modern equity markets (e.g.
modern trading and post-trading systems). While equity markets at first sight appear to
be fairly large in terms of nominal market capitalisation, they remain in effect small. As
illustrated by graph 4.5, the domestic market capitalisation of China`s equity markets -
effectively the Shanghai and Shenzhen stock exchanges - amounts to 27% of GDP.
Though at a similar level to Argentina and Mexico, this places it at the lower end relative
to other emerging markets. However, only a fraction of this is actually traded. When the
limits to tradability are taken into account, China`s real market capitalisation amounts to
no more than 9% of GDP.
Figure 6-3: Equity markets in emerging markets (share GDP)
Domestic market capitalisation, end 2004
0%
50%
100%
150%
200%
250%
300%
C
h
i
n
a

(
t
r
a
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)
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s
i
a
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y
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a
T
h
a
i
l
a
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d
C
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le
M
a
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s
i
a
S
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o
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e

S
o
u
t
h

A
f
r
ic
a
H
o
n
g

K
o
n
g
% of GDP 528
Source: World Development Indicators (2005), OECD (2005) and World Federation of Exchanges (2005).
127
OECD (2005).
85
01_2006_4142_txt_EN.indd 85 12-07-2007 10:43:32
There are various reasons for this state of affairs, all related to significant government-
imposed obstacles that prevent the effective functioning of the equity markets:
Legacv af //s(/ngs based an nan-cammerc/a/ cr/(er/a. Equity markets remain
hampered by the legacy of past listing policies, where listings were rationed and
based on non-commercial criteria geared to supporting ailing SOEs. Accordingly,
equity markets are still dominated by these large, albeit increasingly restructured,
state firms.
128
L/m/(ed (radab///(v af shares. China has three broad categories of shares: (i) A-
shares listed in mainland China, (ii) B-shares traded in mainland China in foreign
currency and (iii) some listed abroad (H-shares in Hong Kong, N-shares in New
York). A second category of shares are the State shares. These have only recently
been subject to tradability liberalisation. The third major category is the so-called
Legal Person (LP) shares, which comes in various forms. In 2002, 44% of an
average listed company`s shares were non-tradable.
129
When a SOE is restructured into a shareholding company it has to issue shares in
all three categories in roughly proportionate numbers. However, only some of
these shares are freely transferable and tradable. This compounds control
problems, as markets cannot exercise control and sanction inefficient firms, e.g. by
selling equity.
130
Figure 6-4: Market Capitalisation and Market Capitalisation of Tradable Shares to
GDP
Source: CSRC (2004).
128
State-owned enterprises represented about 93% of all publicly quoted firms in China in 2003 (Quan &
Huyghebaert 2006).
129
Green (2003).
130
At the end of 2003, about two thirds of total shares outstanding in publicly quoted firms remain non-
tradeable, of which state shares and state-owned legal person shares represented nearly 80%. As a
result, it is impossible to obtain a majority stake in most firms through purchasing their shares in the
secondary market (Quan & Huygebaert, 2006).
0
%
10 %
20 %
30 %
40 %
50 %
60 %
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
Market
capitalisation
Market capitalisation of tradeable
shares
86
01_2006_4142_txt_EN.indd 86 12-07-2007 10:43:33
L/m/(ed ab///(v far shareha/ders (a exerc/se can(ra/. Since the 1990s, state firms
have been increasingly restructured into corporations. However, the purpose of
listing a company in China as part of that restructuring process has not been to
allow changes of ownership but rather to ease the capital constraint a company is
under. When the current share structures were introduced in 1992, the Chinese
authorities wanted to prevent local officials and company managers organising
mass privatisations. Accordingly, only one third of the new share capital was
publicly listed and freely tradable. The remaining two-thirds were granted to the
state on the one hand and allocated to legal persons on the other (e.g. other SOEs,
state holding companies and the like). Holding company stock in China therefore
does not often imply shareholder control. On the contrary, control is often diluted
after listing, as a listed company can raise capital that is of benefit to local
industry. Accordingly, it becomes more important to the sub-national government
that initially sponsored the listing. Moreover, when an SOE becomes listed,
oversight is transferred from central ministries to new organisations (e.g. the
securities market
regulator). Making this
control effective has
proved to be difficult.
131
The difficulty of
exercising control over
company managers
appears to have an
impact on the financial
performance of listed
companies.
L/m/(ed access (a eqa/(v marke(s bv /ns(/(a(/ana/ /nres(ars. Liquidity is further
hampered by the lack of demand for securities, as banks are not allowed to own or
trade equity. Moreover, pension and investment funds are only allowed to hold
limited amounts of equity. These restrictions are motivated by prudential concerns.
However, it leads to a near total absence of institutional investors, with
unfortunate consequences. First, the lack of informed professional investors
renders prices less informative - and hence markets less efficient - as asset prices
often deviate from the real asset value. Moreover, those institutional investors that
are present are often effectively run as state bodies. China`s equity markets instead
rely on retail investors for liquidity. But these are wary about investing in the
equity markets, as illustrated by a survey of the People`s Bank of China, which
found that urban households only committed 7.7% of their savings to equities in
2003.
132
L/m/(ed access bv fare/gn /nres(ars. Foreign investors have not been allowed
access to class A-shares. However, they have access to traded shares via B- and H-
shares. The former covers shares denominated in a foreign currency. The B-share
class was established in 1992 and was China`s first attempt to attract foreign
capital. However, the market continues to lack liquidity. The H-share market is
more dynamic. For example, by the end of 2003, the 93 companies - mostly SOEs
- that had chosen (or been allowed) to list on the Hong Kong Stock Exchange

131
Green (2003).
132
Green (2003).
Table 6.3: A-share securities investment accounts
composition, 2003
Shanghai
Stock
Exchange
Shenzhen
Stock
Exchange
TotaI
Total accounts 35,029,000 33,322,400 68,351,800
Institutional 0.5% 0.4% 0.5%
Individual 99.5% 99.6% 99.5%
Source: CSRC (2004).
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01_2006_4142_txt_EN.indd 87 12-07-2007 10:43:33
since 1993 had raised US$27bn. Moreover, China Construction Bank - one of the
SOCBs - recently raised US$8bn from an IPO in Hong Kong.
To counter these problems, China has undertaken a number of reforms. First, the listing
procedure has become more objective. Companies that intend to issue shares in China`s
domestic market must have someone sponsoring their application for an initial public
quotation. The sponsor will guide¨ the company and then recommends the company and
submits the application documents to China`s Securities Regulatory Commission
(CSRC). After examination and review by the Public Offering Review Committee -
composed mostly of external experts - the CSRC will make the final decision on whether
to approve the application. This could make it easier for companies to gain access to
equity markets. So could the restructuring of the Shenzhen exchange in mid-2004, which
added a market for SMEs.
133
If successful, it would enable more companies to gain
access to equity finance.
Second, the government has initiated a process of converting up to US$250bn of State
shares to tradable equity.
134
This builds on prior efforts to sell off LP shareholdings to
strategic private investors. This process accelerated in 2002 and led in many cases to a
change of controlling shareholder. The authorities also put in place a framework for
Mergers & Acquisitions to facilitate these transfers. Authorities have also put in place
laws on civil proceedings against listed companies. They have also taken a tougher
stance - via criminal law suits - against securities fraud and price manipulation.
135
Moreover, the regulation and supervision function has since 1997 become centralised
under the China Securities Regulatory Commission (CSRC). This is an important shift
for a country where the regulatory framework was for long politicised, as local and
central government officials competed to benefit most from the stock market. Until the
late 1990s, regulatory institutions were under the control of sub-national governments.
For example, the local securities offices that oversaw listing applications were managed
by provincial leaders. Moreover, the cities of Shanghai and Shenzhen managed the stock
exchanges.
136
These local leaders had an incentive to be lenient on regulation and
supervision in order to spare their budgets the reconstruction costs of SOEs and collect
stamp duties from the exchanges. This centralisation, in combination with attaching more
weight to regulatory enforcement and compliance, appears to have improved the quality
of regulation.
More recently, Chinese IPO activities have been booming, despite a short-lived dip in
May-June 2006. Half of the Q2-2006 new listings on the Hong Kong Main Board have
been H-shares from Chinese companies (PwC (2006)). And PwC forecasts for the rest of
2006 are even more bullish. 70 newcomers are expected, representing offerings that
would raise a combined $32bn. Hong Kong remains the preferred location for Chinese
companies considering an overseas listing. But the Chinese government is encouraging
companies to first seek a domestic listing. In June 2006, Bank of China, one of the big
four¨ SOCBs, began trading on the Shanghai stock exchange after a $2.5bn domestic
IPO, making it China's biggest domestic IPO.
133
OECD (2005).
134
Shanghai Daily, 14 November 2005.
135
Green (2003).
136
Green (2003).
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01_2006_4142_txt_EN.indd 88 12-07-2007 10:43:33
6.2.2. Bond markets
Well-functioning bond markets have
significant benefits. They offer a
market-determined term structure of
interest rates, which makes it easier to
accurately price credit risk. They are
necessary for the launch of derivative
markets, which offers a convenient
way of managing financial risks. By
contributing to a more diversified
financial landscape they contribute to
lower funding costs.
137
China`s bond markets are divided into
three segments: government,
corporate and financial institutions
bonds. Overall, China`s bond markets
remain small by the standards of other
emerging markets, as illustrated by
the graph below. By the end of 2004, the amounts outstanding on China`s bond markets
amounted to 34% of GDP.
Of the three segments, government bonds are by far the most developed. They have also
been the main focus of reforms, with limited liberalisation of e.g. maturities, issue terms,
issue calendar and the permission to use the repo market for short-selling. However, the
market remains segmented, with trading divided between the inter-bank market and stock
exchanges. It is also illiquid, with investors tending to buy in order to hold bonds.
The corporate segment is very small (less than 1% of GDP). This is primarily due to
antique regulatory policies, notably as regards issuance.
138
Prudential concerns have led
authorities to an approach aimed not so much at limiting credit risk as fully eliminating
it. For example, corporate bonds need to carry an unconditional and irrevocable bank
guarantee. Bond market participants have little freedom, with the government regulating
the features of issued bonds (e.g. initial interest rates, maturity). Nearly all issuers are
SOEs. Issues are reserved for the financially strongest companies and are moreover
rationed and subject to industrial policy objectives. Additionally, domestic rating
agencies remain vulnerable to influence from companies or sub-national governments.
139
6.2.3. Investment funds
140
The lack of a role for institutional investors in capital markets has been mentioned above.
Establishing institutional investors now comes high on the Chinese agenda for
137
See e.g. Newton and Subbaraman (2002).
138
OECD (2005).
139
OECD (2005).
140
This section builds heavily on OECD (2005).
Figure 6-5: Relative size of China`s bond
market segments
Amounts outstanding, March 2005, US$bn
0
50
100
150
200
250
300
350
Government Financial Corporat e
US$bn
Source: BIS (2005).
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01_2006_4142_txt_EN.indd 89 12-07-2007 10:43:33
transforming capital markets.
141
Institutional investors remain at a very early stage of
development.
The Chinese insurance market is growing rapidly, at around 12% per annum. It
nevertheless remains very small, as total premiums to GDP only amounts to 3.3%. This
is significantly lower than the 8-12% ratio that is often found in advanced economies.
Due to the former SOE-based social security system being substituted by private social
security, huge future opportunities are present.
Even though a former monopoly - People`s Insurance Company of China - was broken
up in 1999 and some new insurers have entered the market, the offshoots of the broken-
up entity dominate the life- and non-life markets. Currently about 80 institutions operate
on the Chinese market. Moreover, pension and collective investment funds remain
embryonic. This is a pity, as they are crucial if China is to cope with its forthcoming
ageing boom.
China has adopted a protective regulatory regime in insurance, under which limits are
placed on product and price competition. Strategically, the China Insurance Regulatory
Commission (CIRC) aims to nurture the development of an insurance sector that is much
stronger financially and more competitive domestically and internationally than at
present.
The last years have seen some relaxation in the control of institutional investors.
Insurance companies and pension funds are cautiously allowing them to invest in
equities. For example, in 2004 they were under certain conditions allowed to place up to
5% of their assets directly in equities and permitted to hold up to 20% of their assets in
corporate obligations.
In view of the limited domestic institutional investor landscape, foreign entry should be
welcome. However, China has committed to less market opening for institutional
investors as compared to banking under GATS. For example, life insurers can only enter
via joint ventures and with a maximum stake of 51%. This is probably a reflection of
China`s unwillingness to cater for foreign entry in the absence of strong national
incumbents reasonably ready to face international competition.
6.3. Informal finance
As private investors in general and SMEs and farmers in particular have problems of
accessing credit via the financial system, a developed system of informal finance - i.e.
operating outside the control of regulators - is in place. The size of the informal financial
sector was estimated at CNY740-830bn in 2003.
142
It is particularly well-developed in
the North-east - where it amounts to 30% of total finance - and the western provinces,
where it amounts to over 60% of SME financing. The corresponding share for the rich
coastal provinces is 30%. Informal finance is also important for providing credit to
farmers.
Informal lending manifests itself in different ways and also varies between regions. It can
for example be provided by individual money lenders, mutual lending networks between
companies or underground financial organisations. Some of the informal lending
facilities are illegal while others are more accepted and protected by the law.
141
OECD (2005), which quotes a seminal 2004 State Council report: Reforming and Developing the
Capital Markets in China¨.
142
OECD (2005) quoting study by the Central Finance University of China.
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01_2006_4142_txt_EN.indd 90 12-07-2007 10:43:34
While providing finance to companies and individuals who find it difficult to access the
formal financial system, the unregulated nature of the sector presents regulators with a
difficult problem, e.g. related to abuses. However, the likelihood is that as the formal
financial system develops the informal sector will wane. For this to happen however, the
reforms outlined above as regards bank financing and capital markets need to continue.
In the meantime, the informal sector fulfils an important economic role.
6.4. Conclusion
China has made significant reforms to its financial sector. Significant resources have
been invested to return the banking system to minimal levels of solvency. Reforms are
also under way aimed at addressing the causes behind the banks' financial problems and
the limited size of the capital markets. However, it remains to be seen whether these
reforms will diminish the state`s pervasive influence in the financial system, as illustrated
by its past and current subordination to industrial policy objectives. It may well be that
more modern financial laws, more market openness to foreign banks with comparative
advantages, stronger corporate governance and more effective internal risk management
systems are insufficient in the absence of the state being willing to relinquish direct
ownership. Currently, that is not on the agenda.
A stronger financial system is critical for China. The importance for growth was
highlighted in the introduction. In addition, China will find it more costly to become
more integrated in the world economy without a sound financial system. For example,
China has long been wary about liberalising external capital flows due to the weaknesses
reviewed above. As it becomes increasingly integrated into the world economy, capital
controls come with increasing costs, e.g. as regards the ability to run an independent
monetary policy. Therefore, addressing the problems identified above is important.
While China has come a long way, much remains to be done.
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01_2006_4142_txt_EN.indd 91 12-07-2007 10:43:34
7. REFORMING THE PRODUCTION SYSTEM
143
While Chinese structural reforms of the financial sector have received most of the
attention, reforms affecting the production system, both public and private, have been
equally challenging and complementary to financial sector reforms.
7.1. Reforming China`s public sector
The number of state-controlled companies (state-owned enterprises and companies
controlled by the state) in China has fallen remarkably over the past decade, as
documented in chapter 1. In 2005 they accounted for 12% of the total number of firms,
versus 60% domestic private enterprises.
144
Furthermore, there has been considerable
restructuring even in the firms that have remained under state control. Employment in
state-controlled industrial companies fell by almost 40% between 1998 and 2003, as 16
million workers were laid off. The size distribution of state-controlled firms in terms of
employment after this massive shake-up has remained virtually unchanged, suggesting
that state divestment was across-the-board.
Many state firms have reorganised into limited liability companies (LLCs) and
shareholding corporations, often with outside shareholders. Collective enterprises
controlled by local governments have restructured and exited even more rapidly than
state-held firms.
Reforms were introduced to improve internal incentives in those firms that remained in
state hands. Since 1999, corporate governance reform of SOEs has become a priority in
China. One component of the strategy is the conversion (corporatisation¨) of SOEs into
legally independent joint-stock companies and the establishment of boards of directors
and supervisors together with laws defining their responsibilities and those of managers.
With this, the authorities have sought to curtail direct government intervention in
enterprise management by creating separate organs to manage state-owned assets. The
second component, which has been given increasing emphasis, is to list corporatised
SOEs and diversify their ownership in a bid to impose further discipline on the boards
and managers. By the end of 2003, more than 1000 state-owned enterprises of middle
and large size have been privatised, through listing some (mostly only a minority) of
their shares on the two national exchanges, Shanghai and Shenzhen, or on the Hong
Kong stock exchange.
The tangible results of the governance reforms have fallen short of expectations,
however. Most studies (e.g. Wei et al 2005) claim that the selection of SOEs for listing
is rarely based on economic merit, attractiveness to investors or the need of capital, but is
highly politicised. This may help explain why SIPs (share issue privatisation) in China
have so far been of only limited success. Many studies indeed show that the financial
and operating performance of SOEs in China even deteriorates after their SIP.
145
Actual
corporate governance practices continue to deviate considerably from international
standards. The boards of directors and supervisors mandated by corporatisation do not
yet have sufficiently distinct identities within the enterprise, and their independence is
143
Based on OECD (2005).
144
Lehman Brothers (2005). Nevertheless, these 12% of firms represent 37% of sales and 50% of
liabilities, indicating that these SOEs are above average size and overrepresented in liability problems.
145
e.g. Sun & Tong, 2003, Quan & Huyghebaert 2004
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01_2006_4142_txt_EN.indd 92 12-07-2007 10:43:34
limited. Top managers continue to be appointed by local authorities or political officials.
The boards tend to function more as an extension of management than as its monitor, and
are effectively bypassed in exercising genuine oversight. The autonomy of managers is
weakened by their dependence on government or political authorities for their position,
their low salaries, and their lack of a direct stake in the firm`s profit performance.
Following the limited success of earlier reforms in improving state-held enterprises`
performance or reducing outstanding debt, the State Assets Supervision and
Administration Commission (SASAC) was created in 2003 as a new agency to address
the problems of the state sector. SASAC is entrusted by the state with capital provider
responsibilities. SASAC has begun to clarify the strategic core sectors in which it will
concentrate its state holdings. One promising initiative that SASAC has taken is to foster
a more open property rights trading system: three major trading centres have been
created nationally to facilitate the auction, sale, and transfer of state company shares and
assets.
Box 7-1: China`s industrial policy
Since the start of its economic reforms in the late 1970s, China has persistently pursued targeted industrial
policies. Industrial policy objectives are embedded in the country`s FDI, Science & Technology,
Education, Taxation policies. In particular, the promotion of large-scale enterprises remains an important
part of central government policy (national champions¨). China regards the establishment of large
conglomerates as the best way for domestic enterprises to achieve economies of scale and compete with
international firms both domestically and in international markets. Company groups have been identified
in the energy, defence, ferrous and non-ferrous metals, motor vehicles, chemicals, transport,
aerospace, pharmaceuticals and electronics sectors. The government considers these areas to be of
strategic¨ importance to the national economy.
146
These national champions¨ were given special
treatment, such as 'easy loans` from state-owned banks and other preferential treatment. The government
encourages these companies to consolidate: many of the M&As that have taken place in recent years have
been government managed.
147
At the same time, enterprises are required to focus on no more than about
three main industries. Through this process of consolidation SASAC aims to improve the efficiency of
investment and strengthen core competencies.
Following these improvements, rates of return have not improved evenly across all state-
controlled companies, even though the reform effort has been fairly widespread across
industries. Looking at the economy as a whole, the performance of state companies
outside the industrial sector is well below that in industry. Within industry, the biggest
improvements have come from the upper end of the size scale. Changes in the middle of
the distribution have been quite modest. The long tail of the distribution of performance
means that a significant group of state firms remain insolvent despite improvements in
the aggregate state sector indicators.
Accordingly, despite the reforms there remain a large number of state enterprises in the
industrial sector that compare poorly with private companies in terms of productivity.
This large tail of badly performing public enterprises continues to drain financial
resources from the economy. Increasingly severe budget constraints in the context of
deteriorating financial performance were a strong incentive for restructuring and
146
Note that these sectors are also of importance for the EU`s competitiveness, see part III of the report.
147
For example, under its 10
th
5-year plan for the auto industry (2000-2005), the government encouraged
100 small automobile manufacturers to merge with the three giants: First Automotive Works,
Dongfeng Automobile and Shanghai Automobile Group
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01_2006_4142_txt_EN.indd 93 12-07-2007 10:43:35
privatisation, but have been held back by several factors: excess employment,
outstanding debt, and ideological pressures.
148
Further reforms are therefore needed. Now that the core industries in which the state
plans to retain control have been decided, a rundown of state-control can and should be
pursued in the remaining industries. In order to improve performance among the
substantial number of enterprises with financial difficulties, it is important to enhance the
market for corporate control. As international evidence on state enterprise restructuring
suggests, transfer of control is the key to improving ownership, with outside owners
being most effective.
149
As in other countries, stronger market discipline is critical in
establishing a firm and lasting foundation for effective corporate governance.
Foreign participation in the form of cross-border mergers and acquisitions of Chinese
companies is also a useful option to facilitate restructuring. Foreign firms are interested
in acquiring domestic enterprises to gain a strategic position in the domestic market:
access to distribution channels, customers and resources embedded in domestic
companies with potential. In return, they bring in the necessary capital, and technological
and managerial know-how. Nevertheless, barriers persist for M&As involving foreign
firms (cf infra).
However, not all state companies are suitable for sale or outside stakeholding. Non-
viable companies need to exit the market and sell their assets. While concern about
potential unemployment from bankruptcy is understandable, an even greater reliance on
market bankruptcy in the short term is advisable with a view to reducing risks to the
banking system and improving the competitive environment.
7.2. Reforming China`s private sector
Despite the various improvements in the regulatory environment over recent years,
significant problems remain for private entrepreneurs. These include a lack of access to
finance (see chapter 6), and impediments through a malfunctioning labour market (see
chapter 10), difficulties in entry, competition and exit, and a range of barriers to
operation and expansion.
7.2.1. Financial constraints
Surveys of domestic private businesses consistently report financial constraints as a
major impediment to business. China is one of the developing countries most dependent
on retained earnings for financing investments.
Table 7-1: The importance of financing constraints for Chinese enterprises and the
consequent importance of retained earnings as a source of finance
Financing constraints
(1=no, 4=major
obstacle)
Sources of financing of fixed asset investment
(%)
Retained Earnings / Equity/ Commercial Banks
China 3.35 57.8% 2.62% 9.3%
East Asia 2.45 35.5% 3.6% 15.2%
India 2.55 27.1% 5.2% 22.0%
Source: Y. Huang, MIT (2005) on the basis of WBES
148
Guo and Yao (2004)
149
OECD (2005)
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01_2006_4142_txt_EN.indd 94 12-07-2007 10:43:35
The reform of the financial sector as discussed in the previous section is therefore of
paramount importance for the continued growth of the business sector, which needs
access to capital for financing investments to enable it to grow to the point where it can
compete on global markets.
7.2.2. Barriers to entry
Despite the large number of new firms emerging from the large reservoir of Chinese
entrepreneurial capacity, business entry is a major problem for private entrepreneurs in
China. Problems include long delays, lack of transparency in decisions, favouritism by
local governments, and pressure to pay unauthorised fees. Long delays in registering a
company had been typical until 1999. Since then improvements have been made. In the
following five years, estimated registration times (on a comparable basis) dropped from
over 100 days to 41 days.
150
Entry nonetheless is limited by the high level of requisite
start-up capital. In China, the minimum capital to start a company is eleven times the
average income in 2003. Limiting arbitrary intervention on the part of local authorities is
one of the most important aspects of the new administrative licensing law. Authorities
are now required to grant a licence unless one of a specified list of valid reasons can be
cited (health, safety, environment, national security, and other¨ laws and regulations).
This law, if properly implemented, could serve to ease entry barriers.
7.2.3. Barriers to exit
Current bankruptcy procedures have a number of drawbacks that prevent the efficient
reallocation of resources. Barriers to exit, by maintaining inefficient firms in the market,
act as an impediment to entry and growth for efficient firms. In addition, the bankruptcy
law does not give adequate protection to creditors, which will prevent them from
providing funding in the first place. Given that creditors have difficulty enforcing their
rights under current legislation, they are reluctant to use bankruptcy proceedings, keeping
inefficient firms alive too long. A new bankruptcy law that will potentially make Chinese
law compatible with international best-practice is currently being drafted. The acid test,
though, will be how it is implemented. At present, there is little experience in
implementing bankruptcy in a market-based fashion.
7.2.4. Legal barriers to operation and expansion
There is no uniform company law governing all enterprises. A number of enterprise
structures co-exist with governing corporations, state-owned enterprises, solely state-
owned corporations, collectives, co-operatives, foreign enterprises and joint ventures.
The basic company law dates from 1994 and was focused on setting a new framework
for the state and private sectors. However, the law sets high minimum capital
requirements on the formation of limited liability and stockholding companies, and does
not allow single-owner firms to be incorporated. Further revisions of Chinese company
law are needed to reduce these limits and to increase transparency and accountability.
151
As already indicated for state-owned firms, stronger market discipline is critical in
establishing a firm and lasting foundation for effective corporate governance. Greater
use of qualified independent directors, including outside directors, should be part of an
150
World Bank and IFC (2004)
151
These issues are an important component in the discussion on China`s non-market status in anti-
dumping legislation.
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01_2006_4142_txt_EN.indd 95 12-07-2007 10:43:35
effort to strengthen the independence and powers of boards of directors and to foster
greater accountability and professionalism among managers. These steps would help to
lay the foundation for a market for managers, which is now lacking, and for the more
widespread adoption of performance-based reward.
7.2.5. Barriers to trade
Based on China`s commitments under the WTO, numerous laws and regulations that
were deemed inconsistent with free trade have been amended or abolished.
Barriers to inter-regional competition and trade have led to market fragmentation
within China, making it impossible to fully exploit the huge Chinese internal market.
The remaining barriers to intra-regional trade (as seen by entrepreneurs) reflect more a
local bias in the legal system, local protectionism and barriers in the labour market, rather
than price and quantity barriers. With the move towards fiscal decentralisation (cf
infra), local governments have had a strong incentive to shield local firms and protect
their tax base.
The central government has been trying to do away with regional protectionism. But
provinces too have been joining forces to create trading blocs, such as the Pan Pearl
River Delta regional trading bloc, the Pearl River Delta region and the Yangtze River
Delta. Data on inter-province trade, observation of regional price differences, the impact
of shocks on the price level and regional specialisation, all point to an increasing market
integration within China, supported by investments in transport infrastructure.
International openness is helping to improve the functioning of domestic markets as
well. The Foreign Trade Law adopted in 2004 enables all firms - private ones included -
to directly engage in importing and exporting. This early fulfilment of a WTO
commitment enables firms to trade internationally without going through Foreign
Trading Companies, giving them much easier access to global markets and reduced
transaction costs. Exporting firms that have to compete on international markets are
typically more productive. Also the competition induced by FDI can improve the
functioning of domestic markets. Although China has seen and stimulated massive
inflows of FDI, these flows and their impact on the local economy have been strongly
influenced by government policy choices rather than market mechanisms (cf supra).
In response to the rapid emergence of FDI-related M&As, the government set up an
M&A notification system in March 2003. The purpose is to promote and regulate FDI, to
derive maximum benefit from the transfer of technological and managerial know-how, to
secure employment and to safeguard competition and national security. The provisions
require foreign investors to notify MOFCOM and SASAC if size and/or market share
thresholds are met.
7.2.6. Barriers to competition
China did not have a competition policy until the reform process started in the late
1970s. Currently the main competition laws and regulations are the 1980 Provisional
Regulations Concerning Development and Protection of the Socialist Competition
Mechanism, the 1993 Anti Unfair Competition Laws and the 1998 Price Law (see Box).
China began drafting a comprehensive anti-monopoly law in the early 1990s, but his has
not yet reached the statute books.
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01_2006_4142_txt_EN.indd 96 12-07-2007 10:43:35
The 1993 Anti Unfair Competition Law was China`s first competition law. Its goals were to protect
competition and prevent unfair trade practices. The Unfair Competition Law (1993) deals primarily with a
number of practices that are best described as unfair trade practices (e.g. trademark counterfeiting, bribery,
misleading advertising, and trade secrets). Some anti-competitive practices (predatory pricing, tie-in sales,
bid rigging, etc) are banned by law. The 1993 Anti Unfair Competition Law provides for criminal
penalties only in the cases of trademark infringement and bribery. SAIC, with its Fair Trade Bureau, is the
administrative body responsible for enforcing the law. It has branches throughout the country. It can take
corrective measures, including imposing fines. While the enforcement record of SAIC is impressive (Lin
2005), most of the cases it has dealt with have involved administrative measures. Only a tiny percentage of
cases have been turned over to the judicial system. This indicates the heavy reliance of competition
enforcement on administrative channels.
The 1998 Price Law complemented the Anti Unfair Competition Law. Its main objective is to fight price
fixing and predatory pricing. It specifically outlaws price cartels.
China`s existing competition laws focus primarily on unfair competition. They do not
deal with monopolisation, abuse of dominant position or M&As. The new anti-monopoly
law is currently being drafted in international consultation, including the European
Commission`s competition service. A distinct feature of the draft is that it deals explicitly
with administrative monopolies.
The delay in enacting this legislation (drafting of which started in 1994) is in part due to
a misplaced feeling that current low levels of concentration preclude anti-competitive
practices and concerns that a competition law could complicate mergers needed for
consolidation.
Using the National Bureau of Statistics (NBS) industrial micro data to compute the
concentration ratios, the OECD (2005) showed that overall concentration in the industrial
sector is indeed not very high by international standards.
152
In many markets,
consolidation could well produce important efficiencies without creating a competition
problem. The reason is that many Chinese firms are undersized as a result of past laws
and policies. The lack of a mid-tier market segment is a particularly serious weakness.
While entry has been substantial, the newly established firms have found it difficult to
grow. This is due to the barriers to growth identified above, more particularly lack of
finance and poor corporate governance. Although China has fifteen Fortune 500
companies (in 2005), most of these firms are large SOEs, especially in resource and
monopolistic sectors. So large firms are mostly a policy story, not a growth story.
Most private companies are (too) small. Out of 3.4 million private firms, only 1 130 have
more than 1 000 employees, and the average firm employment in 2003 was 14
persons,
153
According to estimates based on the NBS micro database, higher
concentration in many Chinese industries would actually enhance the productivity of
incumbent firms. These gains could be obtained through efficiency-enhancing mergers
that facilitate economies of scale.
154
The merger control provisions in a well-designed anti-monopoly law do not prevent
efficient mergers, but only preclude the relatively few mergers whose efficiency benefits
are likely to be outweighed by anti-competitive effects. At the same time, eliminating
152
83 out of the 587 industries are highly concentrated (an HHI of over 1800 points), while 425 industries
are not concentrated (HHI<1000).
153
Y. Huang (2005)
154
OECD (2005)
Box 7-2: China`s competition law
97
01_2006_4142_txt_EN.indd 97 12-07-2007 10:43:36
some of China`s current restrictions on mergers and acquisitions (M&A) would be
beneficial for this scaling-up. Currently takeovers require the consent of the target
company and its workforce, as well as of multiple government departments.
Another factor holding back the effort to set up a comprehensive competition law is a
possible conflict of interest with the pursuit of industrial policy. A serious problem for
competition is the extent of remaining state ownership, especially in the sectors selected
as strategic¨ (cf supra). The introduction of an anti-monopoly law could work against
the government`s policy of encouraging the formation and development of large
enterprise groups in these sectors. This view however again incorrectly equates
competition policy (in casu anti-trust) with a bias against bigness.
With a general anti-monopoly law hopefully to be in place soon, China will have a fairly
complete set of competition laws. Law enforcement will then be the biggest challenge
facing the country. It will be interesting to see how the government balances fair
competition on the one hand against protection of domestic enterprises on the other.
Therefore it is important that China sets up a powerful and independent competition
authority.
One area which is lagging behind in reforms is public procurement policies. Since its
WTO membership in 2001, China has not yet signed up to the Government Procurement
Agreement. Current rules discriminate particularly against foreign-controlled companies
located in China.
7.3. Conclusion
State-owned enterprises continue to be the main source of non-performing loans. These
enterprises therefore need to further restructure their ownership and governance.
Stronger market discipline is critical in establishing a firm and lasting foundation for
effective corporate governance. While concerns about potential unemployment are
understandable, a greater reliance on market bankruptcy for non-viable companies is
nevertheless necessary to reduce risks to the banking system and to improve the
competitive environment.
Despite the vibrant entrepreneurial spirit of the Chinese population, the development of
the private sector remains hampered by substantial barriers to entry, exit and competition.
China`s national champions¨ policy in strategic sectors¨ comes at a cost: an
underdeveloped competitive system. A new set of competition policy laws should
improve the functioning of product markets. A major challenge will be to deal with
potential conflicts between industrial policy, FDI policy and competition policy,
requiring a sufficiently independent competition authority.
98
01_2006_4142_txt_EN.indd 98 12-07-2007 10:43:36
8. REFOCUS PUBLIC FINANCES
The purpose of this section is to review the structure of China`s public finances and
assess to what extent they currently address the challenges China is facing or could be
mobilised to address the challenges China will face in the near future. China`s public
finances have gone through significant changes during the last decade. The current
system was put in place in 1994 with the aims of (i) simplifying the tax system, (ii)
raising more revenue, (iii) increasing the central government`s share of the revenue and
(iv) making the system more stable by replacing ad hoc negotiations with pre-set rules.
155
Public finances have since grown faster than the economy, but remain low by
international standards. They are by and large in a healthy state, with the budget deficit
and national debt in 2004 standing at around 1% and 23.5% of GDP respectively.
156
However, (i) expenditure is not sufficiently focused on China`s upcoming challenges, (ii)
revenue is often raised in a distortive and opaque manner and (iii) poorer regions and
counties have difficulties in financing their expenditure obligations.
8.1. Raising revenue
Until the early 1990s, fiscal revenues decreased, especially those accruing to the centre.
Since the 1994 reform, revenues have expanded 13% per year. The rapid growth is
explained by (i) a rapidly growing economy and (ii) changed incentives as part of the
reform that has put more revenue on the books, (iii) a centralised tax administration that
has proved to be a more effective tax collector.
In terms of structure, China relies more on indirect taxes (VAT) compared to most
OECD members.
Figure 8-1: Structure of selected government revenues (2003)
China OECD
(unweighted average)
35%
42%
3%
20%
Direct taxes
Indirect taxes
Other taxes
Social security
contributions
34%
30%
8%
28%
Source: OECD (2005).

155
Ahmad et al (2002).
156
OECD (2005).
99
01_2006_4142_txt_EN.indd 99 12-07-2007 10:43:36
While there are a number of problems with the current way of raising tax (e.g.
distortions, limited local freedom) thanks to rapid growth, these problems have not had a
material impact on revenues. So far China has managed to raise more and more revenue
thanks to its growth performance without having to adjust the tax rates or bases or by
adding new taxes. However, in view of future demands on additional expenditure (see
below), this may become necessary in the years to come.
8.2. Allocating revenue
The revenue raised is subsequently allocated between the central and local governments.
The 1994 reform also put in place a new system for allocating tax revenues and
transferring some of the revenue allocated to the centre back to local governments.
The ownership of various tax revenues is clearly allocated, with some taxes belonging
exclusively to one layer of government and others being shared. For example, while the
central government has full ownership of excises, customs duties, and VAT and excises
on imports, local governments have full ownership of personal income taxes. Domestic
VAT, by far the most important tax revenue, is shared, with 75% going to the centre.
However, the reformed fiscal system has not been effective in dealing with the large
regional income disparities that have arisen in China over the last decades. On the
contrary, there are signs that the system has accentuated these disparities. The main
reason relates to the allocation of tax bases. Rich regions raise more tax. As the value
added is higher in most cases for secondary and tertiary sectors as compared to primary,
regions rich in the former raise more
tax. These happen to be the coastal
regions, while agriculture is centred
in the central and western regions.
As the coastal regions are richer,
and wage remuneration more
common, these regions also raise
more personal income taxes.
Therefore, tax yields are actually
more unequally distributed than the
already unequally distributed
income.
157
Moreover, compared to previous
systems - where local governments
had more scope to retain revenue
from the centre - local governments
have lost that discretion since 1994.
Local governments have also faced
increased pressure on expenditure, as (i) social responsibilities formerly put on SOEs
have been transferred to local governments as part of the industrial sectors restructuring,
(ii) urbanisation has forced many regions to invest more in basic services (e.g. sewerage),
(iii) the population is ageing, and pension payments remain the responsibility of local
governments, and (iv) minimum service standards have become set by the centre.
Accordingly, while local governments are responsible for around 70% of total
government expenditure, their direct revenues amount to only 45%. As local

157
OECD (2005).
Figure 8-2 Selected regional government budget
deficits
(2003, % of regional GDP)
Shaanxi
Jilin
Xinjiang
Inner Mongolia
Yunnan
Guizhou
Gansu
Ningxia
Qinghai
Tibet
-80% -60% -40% -20% 0%
%regional product
100
01_2006_4142_txt_EN.indd 100 12-07-2007 10:43:37
governments only have very limited ability to set the tax base or the tax rate, this has put
serious strain on many local governments` budgets.
In order to assist local governments, the 1994 reform significantly increased transfers
from the central to local governments. As a result, much of the revenue allocated to the
centre is immediately transferred back to local governments.
The 1994 Transfer System
0%
1%
2%
3%
4%
5%
6%
7%
1997 1998 1999 2000 2001
% GDP
Fixed subsidies: transf ers ensuring that
no regions have revenues lower than
1993 level. Being f aced out.
General purpose transf ers: include
transf ers in f avour of minority regions
and subsidies. The equalisation grant
is the main redistributive element, but
share limited (about 10% in 2000).
Specif ic purpose grants: earmarked
transf ers. Regional policy in the making,
but ad hoc and opaque and in ef f ect
more of a shock absorber.
Revenue returned: 30% increase in
VAT receipts compared to 1993
returned. Favours rich regions.
Source: data from IMF (2004).
Despite their significant size (5.8% of GDP in 2001, up from 1.5% in 1993), transfers
have so far proven insufficient in addressing inequalities in revenue-raising power and
outcomes between regions. The reason is that the major part of the transfers - revenue
returned - favours richer regions that raise more revenue in the first place. Moreover, the
redistributive parts of the transfers - the equalisation grant - remain limited.
158
Nevertheless, the transfers manage to somewhat reduce the inequality of tax yields
between regions, thereby ensuring that regional expenditure is less diverse.
159
Nevertheless, local government spending remains largely linked to local revenues. The
provision of public services therefore varies considerably between regions and ultimately
depends on the level of regional economic development.
160
The further down one goes in
the administrative system, the more pronounced these differences become; sub-regional
governments are more dependent on transfers than the regions are.

158
This is no accident, but part of the negotiations leading up to the 1994 reform. In order to secure
agreement, the equalisation objectives of the transfer system were limited. See, Ahmad et al (2002) for
further details.
159
OECD (2005).
160
Ahmad et al (2004).
101
01_2006_4142_txt_EN.indd 101 12-07-2007 10:43:37
Local governments have therefore had increasing difficulties in meeting their expenditure
obligations, even post-transfers. Some have experienced payment arrears. Most have
resorted to raising additional income from fees and charges. While sub-national
governments are forbidden to borrow directly, some have nevertheless done so illicitly.
Others have shifted investment off the budget balance sheet to non-government entities,
which then borrow money either via banks or bond markets. These practices contribute to
opaqueness and may be risky, as the government at the end of the day is quite likely to
carry responsibility for any liabilities.
8.3. Spending
Since 1994, government expenditure has increased faster than revenue (though the
increase has been slower since 2000). Expenditure as a share of GDP nevertheless
remains low by international standards: at 26%, it is 14 percentage points below the
OECD weighted average.
161
Figure 8-3: Top expenditure items
(Share total, 2003)
AII government
0% 2% 4% 6% 8% 10% 12% 14% 16%
Debt Int erest Payment
Innovat ion, Science & Technology Funds
Agricult ure
Social Securit y Subsidiary Expenses
Securit y and just ice
Ot her expendit ures
Nat ional Def ense
Government Administ rat ion
Educat ion
Capit al Const ruct ion
Cent ral
Local
CentraI government LocaI governments
0% 10% 20% 30%
Government
Administ rat ion
Vehicle
Purchase Tax
Debt Int erest
Payment
Capit al
Const ruct ion
Nat ional
Def ense
0% 5% 10% 15% 20%
Securit y and
just ice
Ot her
expendit ures
Government
Administ rat ion
Capit al
Const ruct ion
Educat ion
Source: National Bureau of Statistics of China (2005).
The government has over recent years aimed at focusing expenditures on human capital
by gradually increasing spending on pensions, social security and education. Even so, as
illustrated by the graphs above, a very large part of the cumulative spending of all layers

161
OECD (2005). If interest payments and social security disbursements are excluded, China`s 24% is
only one percentage point below the OECD weighted average.
102
01_2006_4142_txt_EN.indd 102 12-07-2007 10:43:37
of government remains focused on physical capital (nearly 14% of total expenditure in
2003).
8.4. Budget balance
As overall expenditure has increased faster than revenue, the fiscal position deteriorated
until 2002. Since 2002, despite continued increases in revenues, China has managed to
reduce its deficits somewhat. Accordingly, the stock of national debt reached 25% in
2002, before declining to 23.5% of GDP in 2004. The deficits are primarily financed
domestically, as the share of foreign debt was only 4% of GDP. Thanks to buoyant
growth and low interest rates, the deficits are nevertheless manageable. Interest payments
in 2002 only amounted to 2.6% of
revenue (0.6% of GDP).
162
Even so, China`s public finances are
facing strains in the near future and
the current structure of expenditure
and negative, albeit moderate,
balances restrict China`s margin of
manoeuvre. One source of problems
relates to a number of direct and
contingent liabilities that China is
facing. For example, as explained
elsewhere, the banking sector is
riddled with non-performing loans.
Significant capital injections have
already been made, but new bad
loans are likely to materialise.
Accordingly, it has been estimated
that it would cost up to 30% of GDP
to fully resolve the bad loans crisis.
The restructuring of SOEs, as reviewed above, is also a costly process. Moreover, the
indirect financing resorted to by sub-national governments referred to above may also
require further budgetary resources, estimated at 3-10% of GDP.
163
8.5. Refocusing expenditure to address social challenges and provide a better
foundation for growth
China is facing a number of social challenges in the short- to medium-term future. In the
wake of economic reforms, individuals have had to carry more of the financing burden of
acquiring education and insuring themselves against social risks. Households accordingly
save a high proportion of their disposable income. However, large parts of society are
increasingly excluded from adequate social insurance and education. To reduce potential
tensions arising from the inequality of access and to moderate the macro-economic
imbalances resulting from the high level of savings, public finances may have to take on
a larger share of the responsibility.

162
OECD (2005).
163
OECD (2005).
Figure 8-4: China`s public finances
0%
5%
10%
15%
20%
25%
30%
35%
1978 1985 1990 1992 1994 1996 1998 2000 2002
%GDP
-3.5%
-3.0%
-2.5%
-2.0%
-1.5%
-1.0%
-0.5%
0.0%
0.5%
Revenue
Expendit ure
Balance (right -hand
scale)
Source: National Bureau of Statistics of China (2005).
103
01_2006_4142_txt_EN.indd 103 12-07-2007 10:43:38
8.5.1. Social insurance
Before the economic reforms were initiated in the late 1970s, companies provided basic
insurance against social risks to their employees. As part of the economic reforms,
companies typically no longer provide these insurances. So far, the state has not fully
taken on the responsibility, although China has had a comprehensive system for social
insurance - covering pensions, health, unemployment, injury and maternity leave - in
place since 1997. Accordingly, the coverage of social insurance - notably in the area of
health - is no longer as comprehensive as it used to be. The costs for the individual have
increased, though, as the new system relies on high private contributions (41% of the
total wage bill).
Table 8-1: Social security contribution rates
(% of wage, 2005)
Pension HeaIth UnempIoyment Injury Maternity TotaI
Enterprise 20 6 2 1 1 30
Individual 8 2 1 11
Total 28 8 3 1 1 41
Source: OECD (2005).
The emerging system remains segmented between rural and urban areas. Moreover, the
coverage varies widely between regions, but also between types of enterprise. The new
system also remains poorly administered, with e.g. a large share of private firms not
participating in the scheme despite its compulsory nature. The remainder of this section
reviews recent developments and remaining challenges in the two largest parts of the
social insurance system: pensions and health.
Pensions. The pension system is currently changing. Since the reforms started, it has
moved from a pay-as-you-go (PAYG)
system, via a hybrid system combining
defined benefits and contributions, into
today`s three-tier system.
The first two tiers of the new system are
mandatory. The first gives the right to a
flat-rate pension equal to 20% of
average local wages in a given locality,
provided that the pensioner has
contributed for at least 15 years. The
second tier provides notional individual
accounts. This gives the pensioner the
right to a monthly annuity based on past
contributions and accumulated interest.
Only those companies that comply with
these first two tiers have the right to
provide third-tier funds. However, these
are too costly for many state-owned firms to provide and, accordingly, coverage
remains very limited (7 million people in 2003).
The transition to this system has not been without problems. The cost issue has not
yet been solved. For example, imbalances in pension systems run at sub-national
level cannot be counterbalanced by transfers between regions. Instead, the central
Figure 8-5: Dependency ratio
0
20
40
60
80
100
1955 1970 1985 2000 2015 2030 2045
Tot al
Child
Old-age
Source: United Nations (2005).
104
01_2006_4142_txt_EN.indd 104 12-07-2007 10:43:38
government is responsible for financing deficit regions, while surplus regions can
either lower contribution rates or invest potential surpluses. Moreover, coverage
remains low. In 2000, participation was restricted to 14% of total employment and
registered unemployment. Private firms and foreign firms remain reluctant to
participate. In addition, due to variations depending on enterprise type, portability
between firms and regions is limited. The resulting segmentation is another barrier to
the development of a national labour market.
As China over the next decades will experience the fastest rate of ageing among
developing countries, a sounder pension system needs to be put in place sooner rather
than later. The reasons behind China`s rapid transformation are an increase in
longevity coupled with the one-child policy that has been in place since the 1970s,
which exacerbated the decline in fertility rates. As a result, the growth rate of the
workforce will soon experience a sharp slowdown.
164
Overall, from 2015 onwards,
the size of the working population compared to the old and young (dependency ratio)
will decrease, as will the overall size of the population (see graph). Accordingly, as
there will be fewer people working relative to pensioners, the PAYG elements of the
current system will be more difficult to sustain. The funded parts of the system (tiers
2 and 3) therefore need to become more important. Were these funds to be allowed to
invest in Chinese companies, it would have the added benefit of providing an
important boost to the development of China`s capital markets.
Health. China`s economic transformation
has been accompanied by a switch from a
publicly provided system to something
more like a market-based one. However,
there are signs that this has significantly
decreased access to health care, making it
the privilege of those with the means to
afford it.
165
While China`s overall expenditure on
health - 5.3% of GDP in 2002 - is in line
with some OECD members, the public
share of expenditure has decreased sub-
stantially since the beginning of reforms.
In 1994, public spending on health
amounted to 4.2% of on-budget spending.
In 2002, the corresponding figure was
2.9%, or 0.6% of GDP. Instead,
individuals have come to carry a much
larger share of the cost of medical care. For example, in 1980 the share of out-of-
pocket expense in medical care amounted to 16%. In 2001, the corresponding figure
was 61%.
166
As a result of the decrease in public spending on health, the coverage of health
insurance has declined substantially. In 2003 only half of the urban population and

164
Qiao (2006).
165
Donald and Benewick (2005).
166
Kanbur and Zhang (2003).
Figure 8-6: Health expenditure
(2002, total, % of GDP)
0
2
4
6
8
10
12
CHL CHN MEX BRA ARG OECD
%GDP
Source: World Bank (2005).
105
01_2006_4142_txt_EN.indd 105 12-07-2007 10:43:38
one fifth of the rural population were covered. Moreover, health inputs¨ in terms of
personnel and hospital beds have decreased substantially. For example, between 2001
and 2002 the number of doctors decreased from 2.1m to 1.8m.
167
Not surprisingly, shifting the burden of health care to the individual has engendered
large divergences in access, with health care becoming prohibitively expensive for
poor people. A survey on the equality of access to health care by the World Health
Organisation (WHO) in 2000 ranked China fourth from bottom.
168
The switch to a
market-based system has also increased the gap between urban and rural regions,
with poorer regions providing less health care.
In terms of health outcomes, China continues to perform well compared to other
developing countries and even developed countries. For example, life expectancy has
reached that of some OECD countries. However, there are signs that improvements
are levelling off. For example, infant mortality rates declined dramatically from the
1960s to the 1980s but have since levelled off.
169
8.5.2. Education
In order to continue to grow and move up the value-chain, China needs a well-educated
workforce. This is a well-recognised
challenge in China, and as evidenced
elsewhere in this report, China is rapidly
moving up on the ladder, in part thanks
to a high level of relevant skills. It is
therefore not surprising that education is
a priority in China and the government
has gone to considerable lengths to
improve it.
In terms of the level of funding, China
overall spends a high amount on
education, around 5% of GDP, which is
only 1 percentage point of GDP less
than the OECD average.
170
This makes it
one of the most developed transition
countries. However, the public share of
that spending is much lower in China,
amounting to 3.2% of GDP in 2002.
Low public spending is compensated by
high levels of private spending, amounting to nearly 2% of GDP in 2000. For example,
spending on tuition fees as a share of total expenditure on education rose from 2.3% in
1991 to 12.5% in 1998.
171

167
Donald and Benewick (2005).
168
Ibid.
169
Kanbur and Zhang (2003).
170
OECD (2005).
171
Kanbur and Zhang (2003).
Figure 8-7: Public and private education
expenditure (2000)
0
1
2
3
4
5
6
7
China Transit ion
count ries
Ot her developing
count ries
OECD
%GDP
Privat e
Public
Source: OECD (2005).
106
01_2006_4142_txt_EN.indd 106 12-07-2007 10:43:39
Education is the responsibility of local (sub-regional) authorities. As highlighted
elsewhere, their levels of prosperity vary significantly. This inequality - which has
increased significantly since the beginning of economic reforms - is reflected in their
revenue-raising capacity and ultimately - and in spite of fiscal transfers between regions
- in the level of expenditure they can afford.
It is therefore not surprising that the quality of education varies significantly between
regions. Rich, urban regions generally have much higher standards while poor, rural
regions typically find it difficult to provide even basic levels of education. This is
reflected in education outcomes. While illiteracy, for instance, has decreased over the
years, the differences between urban and rural regions have increased.
172
For example,
the number of illiterate people aged 15 and above exceeded 25% in some regions in
2002.
173
Education has been a priority in China during the last decade. The latest official goal was
to spend 4% of GNP on education by the end of 2005. Despite higher spending, this
objective proved elusive. China has also tried to devote particular resources to poor
counties in order to extend compulsory education to 9 years schooling in urban areas and
6 years in rural areas. In spite of these efforts to focus spending on basic education,
tertiary education continues to receive a higher proportion of public spending compared
to primary and secondary.
172
Kanbur and Zhang (2003).
173
Donald and Benewick (2005).
107
01_2006_4142_txt_EN.indd 107 12-07-2007 10:43:39
9. DEVELOPING CHINA`S INNOVATIVE POTENTIAL
The importance the Chinese authorities attach to developing an innovative capacity is
unprecedented. President Jintao stated at the National S&T Conference in Beijing in
January 2005 that the goal was to transform China into a nation of innovation in 15
years. Only when the efficiency of the whole national economy is considerably raised
through technological and management innovation, can the country succeed in building a
well-off society¨. A new phase of development based on innovation will avert the
danger of relying excessively on low cost, to build and maintain China`s competitive
position in world markets in the future. Furthermore, given the increasing pressure that
growth currently exerts on the country`s resources and environment, embracing
innovation as a way of tackling energy and environmental issues has become an
inevitable choice. This new innovation phase is a daunting objective for China.
To bridge the S&T gap with the US, EU and Japan, China needs to boost its investment
in public R&D and education infrastructure and improve the efficiency of public
spending. But developing a national innovative capacity will require, over and above
public S&T infrastructure, the right framework conditions for translating S&T
expenditures into innovation and growth. This necessitates a sufficient 'demand` for
innovation to reward and incentivate successful innovators, and hence end users willing
to pay for innovation and effective intellectual property rights (IPR) schemes. Well
functioning product, capital and labour markets and good industry-science links are
needed to give innovators access to the necessary physical, financial, human and R&D
resources. This is perhaps the most challenging aspect for China.
Opinions on the sustainability of China`s S&T growth and its capacity to acquire
technological leadership are diverse. To analyse whether China can succeed in
developing its innovation capacity, we have to analyse its fundamental strengths and
weaknesses and judge whether it can tackle its weaknesses and achieve its ambitious
objectives by undertaking the necessary reforms.
9.1. China`s strengths in building innovative capacity
China`s strength in innovative capacity comes first and foremost from its large potential
internal market, providing an enormous incentive for R&D investments for Chinese
entrepreneurs. In addition, being close to the market is a major location factor for
attracting multinational firms to site their R&D investments in China. But this is still
mainly a potential strength, which awaits structural reforms to fully unleash its power.
Another important component of S&T growth in China is its huge pool of human capital
for R&D. This is important in terms of attracting enterprises (both local and foreign) and
research institutes to invest in R&D activities in China. Chapter 2 detailed the rapid
increase in researchers and tertiary educated employees, most notably Scientists and
Engineers. Stimulated by increased funding and reforms in the higher education system,
the number of new students entering the higher education system has increased
dramatically. And there is still a huge potential supply building up over the coming
years, before the adverse demographic structure sets in.
Finally, political stability and leadership is important in terms of committing to a
coordinated and coherent innovation policy in a focused way and with a long-term
perspective. The current build-up of Chinese S&T capacity is supported by a targeted
S&T policy, focusing R&D funding on specific areas where the contribution of the public
108
01_2006_4142_txt_EN.indd 108 12-07-2007 10:43:39
R&D to private R&D and growth can be best assured (cf chapter 2). This S&T policy is
supported by a political leadership with a long-term perspective, who have put
innovation on the long-term policy agenda (cf latest 11
th
5-year plan).
9.2. China`s challenges in building Innovative Capacity
Despite these nascent strengths, Chinese S&T policymakers still have many challenges
to tackle.
9.2.1. Developing the public research infrastructure
First, there is the need to develop the public research infrastructure at public research
institutes, universities and institutes of higher education.
(i) Public funding for basic research
The long-awaited new S&T plan, crafted by and to be implemented by the Ministry of
Science and Technology (MOST), will set the tone for science in China for the next 15
years. R&D spending by all sources will rise to 2.5% of GDP by 2020. By 2010 it should
have reached 2% of GDP, 40% of which will come from central government R&D.
174
Basic research is slated to climb from 6% of R&D in 2004 to as much as 15% in 15
years. Most of this funding will be heavily concentrated in specific areas. The plan
specifies 16 major engineering projects (including next-generation broadband, large scale
oil and gas exploitation, transgenic plant breeding, drug development, manned moon
exploration, design of large aircraft) and four major basic research programmes (protein
science, quantum physics, nanotechnology and developmental and reproductive biology).
Funding for these big programmes will be concentrated in a limited number of excellence
centres.
A major source of funding for basic research is the National Natural Science Foundation.
Set up in 1986, it was modelled on the US National Science Foundation. Its grant
selection procedures are based on peer review involving mostly Chinese scientists-
experts. More than half of its support goes currently to universities, the rest to
government research institutes.
175
In the new plan, the NNSF budget is drastically
increased to fund the big programmes specified in the plan. Nevertheless NNSF also
plans to integrate the national strategic needs, specified through the big programmes,
with an independent development of science scenario. One worry is the lack of
transparency and open competition in allocating funding to these big programmes. Since
almost all good scientists are involved in a big science project, there are not many good
Chinese scientists left who can objectively evaluate. More internationally open
evaluation procedures should be considered.
174
China`s State Council.
175
World Bank (2001).
109
01_2006_4142_txt_EN.indd 109 12-07-2007 10:43:39

(ii) Reforming Public Research Institutes
In order to improve the efficiency of its basic funding, China has substantially reformed
the public research landscape. As a legacy of the old system, Public Research Institutes
(PRIs) conducted most of Chinese basic and applied research. Most of these PRIs
operated in isolation from production activities. To respond to these problems, the
government initiated major changes in the funding and management of these PRIs. The
goal was to overcome the entrenched problem of research projects not being motivated
enough by the actual needs of the market.
Box 9-1: Transformation of Public Research Institutes
Public research institutes are affiliated with government ministries or the Chinese Academy of Sciences.
Within the Academy, the role of its 120 institutes has been redefined; their work has been refocused on
priority areas and personnel have been upgraded. Many people have been restructured out of the picture.
Research institutes which used to report to government ministries have been subjected to even more radical
reforms. Some institutes were merged with existing SOE enterprises, while others were transformed into
enterprises and others reorganised but remained as national research centres.
Source: World Bank (2001).
(iii) Reforming Research Universities
Universities are still predominantly active in Science & Technology Training. They have
a significant capability for basic research but as yet represent only a small share of R&D
effort. To get universities to contribute more to R&D, the Chinese government wants to
distinguish between research and teaching universities. The number of universities has
been reduced, concentrating into a smaller number of better scaled institutes, better able
to meet top international standards. Funding is concentrated on top-notch universities and
networks of excellence.
176

The entrepreneurial spirit of the universities is remarkable. Stimulated by strong
incentives (allowing researchers to keep at least 50% of earnings from
commercialisation) new companies have spun off from university research. Universities
have also invested in science parks and are expanding their cooperation with foreign and
domestic enterprises, enabling universities to generate considerable extra income. This
dynamism is a positive and unique Chinese asset. Nevertheless, clearer regulations are
needed on how the results of research conducted as part of the universities' duties and
publicly funded, may be exploited privately.
177

(iv) Reforming Higher Education
Various reforms in the higher education system have been carried out since 1992, the
overall objectives being to achieve both qualitative and quantitative growth.
In 1995, the so-called Project 211 was established by the Ministry of Education, and
followed in 1998 by Project 985.
178
These projects focused on creating 100 key
universities in China of world-class level. Beijing University and Tsinghua were singled

176
China has called for the establishment of 100 first-class universities and 30 world-class research
universities by 2020. Beijing University and Qinghua University in Beijing, and Fudan University
and Jiaotong University in Shanghai qualify for meeting top international standards.
177
World Bank (2001).
178
Section based on F. Huang, Qualitative Enhancement and Quantitative Growth: Changes and Trends
in China`s Higher Education, Higher Education Policy, 18, 2005, 117-130.
110
01_2006_4142_txt_EN.indd 110 12-07-2007 10:43:40
out to be the major receivers of funding, followed by a second tier of universities.
Another measure has been the merger of specialised and smaller sized institutions into
large scale comprehensive universities, more focused on research, and covering all
academic disciplines. Merging of schools of higher education has helped to reform the
management of higher education institutions, optimising the allocation of resources and
improving standards. The Chinese MoE has also introduced a central system of quality
assessment of teaching in Chinese universities, administered through the Centre for
Assessment of Higher Education, which was set up in 2004.
In order to meet demand and policy targets, a large scale effort to achieve quantitative
growth in Higher Education capacity has been made since 1999. Whereas the key
universities were allowed to focus on qualitative enhancement, the quantitative
expansion of Higher Education capacity has been achieved primarily in less prestigious
provincial or local level regular higher education institutions. In addition, the private
education sector has been supplying part of the required capacity.
Despite the initial strong quantitative take-off, significant issues remain to be tackled.
First, despite the growth in quantity, there is a looming talent shortage. Companies,
particularly in services sectors, and foreign firms are finding that graduates are top-heavy
on theory and hard skills and are lacking the necessary soft skills like problem solving,
project and team work and languages. Secondly, more emphasis needs to be placed on
quality assurance. The Chinese government has already embarked on restructuring the
higher education landscape into larger sized, full-curriculum institutions. But China
should also seek to improve the quality of the system beyond the top-notch universities,
by giving more autonomy to the institutions in developing programmes, admitting
students, staffing and funding. It should integrate the growing private institutions into the
formal education sector. Finally, it should tackle the problem of unequal access to
educational services across provinces, by decentralising more educational authority to the
provincial level and expanding distance education. If China fails to tackle the S&T
inequality issue, a dual innovation system¨ is likely to arise, with on the one hand a
rapidly growing restricted number of knowledge-intensive institutions, locations and
individuals and, on the other, the vast majority of the population with a low level of
education and unable to benefit from China`s knowledge investments. These knowledge
gaps are reducing the effectiveness and dissemination effects of S&T investments and
might even pose a threat to the future social and economic stability of China.
9.2.2. Developing private research
Secondly, and perhaps more challenging for China, private research infrastructure needs
to be improved and better geared to creating innovative products and processes that
support Chinese sustainable development. Direct support, by providing subsidies or tax
credits, should use open transparent procedures and competitive allocation. But
supporting private R&D investment goes beyond providing subsidies and taxes. It also
implies putting the right framework conditions in place for firms to have incentives to
invest in R&D.
First there is the issue of improving access to finance, especially for the smaller sized
enterprises. Reforms of the financial sector (cf below) are important in terms of giving
innovative firms access to financial capital to finance their R&D investments and growth.
This is especially true of small, high-tech, high-risk start-ups. The Chinese venture
capital market is still underdeveloped. Many venture capital companies are run by
government officials with little skill in evaluating the technical and marketing potential
111
01_2006_4142_txt_EN.indd 111 12-07-2007 10:43:40
of start-up projects. In addition, venture capitalists have few opportunities to sell their
ownership rights.
Second, product market reforms are needed to capitalise on China`s huge market
potential. This requires more reliance on competitive forces in product markets to reward
the most efficient innovative firms. Reforms of product markets have been discussed
above.
Enforcement of intellectual property rights (IPR) remains a major concern for foreign
firms in particular, but increasingly also for domestic firms. One negative consequence of
poorly enforced IPR protection is that companies will limit the amount and the nature of
the R&D they do in China. While substantial legislative changes have been made, as a
result of China`s WTO accession, weak legal enforcement of IPRs make deterrence
ineffective, dampening the incentives for firms to locate IP or develop local innovation
activities in the first place. This is ultimately also against China`s interests.
Box 9-2: Intellectual Property Rights in China
As part of their open door policy¨, Chinese leaders realised that IPR protection would be crucial for
attracting FDI. IPR legislation was essentially designed to reassure foreign investors. Since the 1980s, the
State has promulgated a number of laws and regulations covering the major aspects of IPR protection.
These include the 1984 Patent Law, the 1982 Trademark Law and the 1990 Copyright Law. China has also
promulgated a series of rules for the implementation of these laws and has signed several international
conventions, including the Patent Cooperation Treaty. In 2001, when it was admitted into the WTO, China
made the necessary revisions to these laws in order to comply with the WTO`s Agreement on Trade
Related Aspects of Intellectual Property Rights¨.
Administrative measures have played a very important role for IPR protection in China. Several
government agencies are assigned to protecting IPR. They include the State Intellectual Property Office
and MOFCOM. In 2004, China established the State IPR Protection Work Team, headed by a Vice-
Premier of the State Council, responsible for planning and coordinating the work on IPR protection.
Lately, especially after China was admitted into the WTO, it has gradually improved judicial protection for
IPR. For example, the revised PRC Trademark Law, Patent Law and Copyright Law all established the
judicial review system for administrative decisions.
China`s major challenge is how to enforce the IPR legislation. Despite all the efforts taken to improve the
situation, IP violations in Chine have been growing,
179
It is important to distinguish two issues:
counterfeiting and piracy on the one hand, and patent infringements on the other hand.
With respect to counterfeiting and piracy, the main weaknesses are burdensome procedures for initiating
and taking cases in courts, the complexity of the administrative organisational structure, with a lack of
cooperation between and within enforcement agencies, a lack of enforcement at the local level and local
protectionism, and lack of financial and human resources for the administrative enforcement agencies.
With respect to access to technology secrets and patenting, improved IPR enforcement should offer
companies better protection, but the situation will remain far from perfect. This is particularly true for
foreign firms, as in many key sectors China is seeking to extract technology and IP from foreign firms to
support the development of Chinese industries. While companies should of course register their
trademarks and patents and prosecute violators, litigation is likely to remain an imperfect means of
protecting IP. The most successful companies complement their IPR strategy by adopting strategic and
operational measures to protect their IP, thus lowering their litigation costs and improving the chances that
their IP will remain safe. The best companies reduce the chance that competitors will steal their IP by
carefully selecting which products and technologies to sell and manufacture in China, using secrecy and
security measures, building in complexity in product and process design to make it harder to copycat, and
managing the spillovers through researcher mobility, e.g. by building in non-compete clauses in labour
contracts.

179
EC (TRADE), 2006, EU Trade and Investment with China: Changes, Challenges and Choices.
112
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Beyond focusing on the creation of know-how, the capacity of the Chinese S&T system
to diffuse and absorb know-how needs to be further developed. User-producer interfaces
need to be expanded. Also, private R&D should be more closely linked to the public
research infrastructure, which means further improving industry-science links.
And finally China should open up its S&T system internationally. China needs to access
the rapidly growing global knowledge base, by continuing to attract FDI, but also by
improving the use of modern telecommunication/Internet. China needs to beef up its
collaborative effort in international scientific initiatives. Although it has international
agreements in S&T with more than 150 countries, active participation is low, both in
terms of Chinese involved in projects abroad, as well as foreigners involved in projects in
China (cf above).
9.3. Conclusion
China will not become a technological superpower soon. There are still several
weaknesses and risks that need to be tackled. Building an innovative society requires an
integrated policy at the highest level of the state. But taking into account China`s
determined growth performance in the recent past, it would be naïve to doubt that China
will be making progress towards its targets, bringing its strengths into full play.
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10. ABSORBING SURPLUS LABOUR
China`s abundant and growing labour supply is obviously an important component of its
success in world manufacturing. Almost 900 million people are in the age group 15-64,
and they will reach one billion in 2015. The majority of these people live in rural areas
and are unskilled. This pool of unskilled labour has underpinned China`s economic
growth over the past two decades.
At the same time, this abundance of labour may challenge the sustainability of socio-
economic development when labour supply exceeds demand, leading to rising
unemployment rates. The main challenge facing China`s labour market in the coming
years will be to absorb the surplus labour into quality jobs. Due to the restructuring
process speeded up by China`s WTO accession, China`s state-owned enterprise sector
may shed up to five million people annually in the coming years. The restructuring of the
agricultural sector will also lead to dramatic reductions in the demand for agricultural
workers.
180
In addition, China is experiencing a demographic boom that will increase the
population aged 15-64 years at least until 2015, despite an increasing education level
which keeps young people out of the labour market for longer. It is only in the medium to
longer term, around 2035, that the ageing challenge will set in, to reduce the supply
pressure.
A rise in unemployment would raise important challenges for the labour market in China.
They could be limited by stronger economic growth, especially in the private sector and
the more labour-intensive service sectors, which have generated the most jobs in recent
years. Nevertheless, skills mismatch will be a problem. The sectors where China is
building comparative strengths on world markets and where most of the growth is
happening demand higher skills, which are not readily available among laid-off workers.
The increase in productivity will reduce the demand for low-skilled labour, leading to
major changes in the composition of employment. In addition, the skill bias is entwined
in the rural-urban divide, with higher skills being more present in urban than rural areas.
The upshot is substantial challenges for inequality and cohesion. It will also put a heavy
demand on the Chinese educational system (cf below). Against this background, this
section first reviews the main trends in the Chinese labour market before outlining the
progress on reforms and discussing the main challenges that lie ahead.
10.1. Trends in China`s Labour Market: rural vs. urban employment
The labour force participation rate in China is very high by international standards: in the
late nineties, more than 80% of the working age population was on the labour market.
181
Most of the employment is in the rural sector, although the share of rural employment in
total has been steadily declining, from 75% in 1980 to 66% in 2002. This is due to
proportionately stronger and sustained employment growth in the urban sector: jobs in
the urban sector have increased by 3% a year since the 1990s, while overall job growth
averaged just 1%.
180
OECD (2005)
181
IMF (2004)
114
01_2006_4142_txt_EN.indd 114 12-07-2007 10:43:41
Figure 10-1: Employment and GDP
a. Urban and rural employment b. State owned employment
80
90
100
110
120
130
140
150
160
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
Urban
employment
Rural
employment
1990=100
Total
20%
30%
40%
50%
60%
70%
80%
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
Other
State owned
entreprises
Note : share in urban employment
c. Secondary sector GDP & employment d. Tertiary sector GDP and employment
50
100
150
200
250
300
350
400
450
500
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
Real
GDP
Employment
50
100
150
200
250
300
350
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
Real
GDP
Employment
Source: NBS, Statistical year books, various issues
Job growth in urban areas was achieved despite layoffs at SOEs equivalent to more than
10% of the urban labour force. The government`s campaign to limit loss-making SOEs
caused some 23 million state workers to lose their jobs between 1993 and 2003 (IMF
2004). These losses were more than offset by job growth in the private sector, including
foreign-funded enterprises. The pace of job creation was much faster in the coastal
provinces and in the service sector (cf chart 4-10). In addition, about 80 million jobs
seem to have been created in 1995-2002 in the informal sector, although the quality of
the labour market statistics makes it difficult to analyse these data.
182
The majority of rural workers are employed on farms, although the share of farm
employment in rural employment has been decreasing: from 91% in 1980 to 65% in
2002. Rural employment growth was more rapid in the late 80s and early 90s, especially
in Town and Village Enterprises (TVEs), which increased their share in rural
employment from 9% in 1980 to 27% in 2002. Nevertheless, overall growth in rural
employment has been limited, especially since the late 90s and early 2000s as rural-to-
urban migration increased.

182
IMF (2004)
115
01_2006_4142_txt_EN.indd 115 12-07-2007 10:43:42
10.2. Unemployment: an understated phenomenon?
The poor quality of the data makes it difficult to estimate the true level of unemployment
in China, particularly given the difficulty of calculating the scale of layoffs at state firms
(see the issue of xiagang workers, cf below).
So far, there has only been a slight increase in registered urban unemployment. up from
2.5-3% in the 1990s to slightly above 4% in 2004.
183
If workers laid off from SOEs who
remain registered with reemployment centres (xiagang) are taken into account, registered
unemployment reached more than 5% in 2004. However, it is unclear how many of the
xiagang workers in the informal sector can be considered as truly unemployed.
184
Figure 10-2: Registered Urban Unemployment
200
300
400
500
600
700
800
900
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
2
2.5
3
3.5
4
4.5
in Thousand in %
Number of Unemployed
Unemployment rate
in % of active
Source : NBS, China Statistical Yearbook, various issues
With respect to rural unemployment, the low productivity of China`s farmers compared
with other Asian countries suggests a higher level of underemployment than elsewhere in
Asia, although this is difficult to document with reliable statistics.
185

183
Gu (2004) and Cai and Zao (2004) cite alternative estimates of unemployment, with a rate around 7-
8% for all workers.
184
The Chinese central government required reemployment centres to be set up in those state-owned
enterprises that had laid off workers and staff members, cf below. It is unclear what proportion of
xiagang workers should be classified as unemployed according to ILO guidelines, as they often work
in informal jobs. Although many of these workers may want higher quality jobs in the formal sector,
they are not strictly considered as unemployed so much as underemployed.
185
See for instance OECD (2002) and IMF (2004). OECD (2002), using the average level of productivity
as a benchmark for the agricultural sector, estimates rural hidden unemployment to be around 200
million. Most of the other studies give a figure near 150 million.
116
01_2006_4142_txt_EN.indd 116 12-07-2007 10:43:42
10.3. Projections on China`s labour market: can demand meet supply?
In the near future, the Chinese labour market needs to continue to absorb surplus workers
from the rural and the SOE (State Owned Enterprises) sector. The supply of urban
workers is likely to continue to rise as rural to urban migration and SOE restructuring
continue, and as rural and urban enterprises downsize to increase efficiency in the face of
world market competition.
In spite of earlier layoffs, much obsolete production capacity remains. For example, the
government estimates that 15% to 20% of SOE employees could be released without
affecting the output of their firms and outsiders.
186
A potentially even bigger issue for the urban labour market, however, is the continued
flow of rural workers migrating to the cities. A large proportion - estimated by the
OECD to be as high as 200 million rural workers - is currently under-employed. WTO
accession will entail further restructuring in rural areas.
187
So far, the rapidly expanding private sector and the introduction of reemployment centres
have helped to absorb the rising ranks of unemployed. The non-state-owned sector has,
since 1992, provided more than 95% of the nation`s new job opportunities. This growth
is underpinned by tremendous productivity gains, leaving a relatively low employment
elasticity. This raises the issue of whether output growth in the private sector can
continue at a pace sufficient to absorb the larger supply of labour, particularly of the
lower skilled. In this, the role of the currently underdeveloped services sector needs to be
improved.
Table 10-1: GDP and employment
Employment
Growth rate
%
Employment
elasticity
Productivity
Growth rate
%
1981-1985 3.3 0.308 7.4
1986-1990 2.6 0.331 5.3
1991-1995 1.2 0.100 10.8
1996-2000 0.9 0.180 7.4
Source: NBS, IMF (2004).
IMF
188
projects that with a non-agricultural growth of 7.5% annually up to and including
2010, and an elasticity of employment growth to output growth of 0.45, the labour
market can absorb about 3-4 million surplus rural and SOE workers annually in 2004-
2006. This implies, however, that if most of the SOE downsizing takes place in the first
years and rural migration takes place as targeted in the 10th Five-Year Plan, the
unemployment rate could double to a peak of over 10% in the near future, but would
decline again by 2010 as the natural increase in the labour force slows and SOE
downsizing is completed. These projections are of course subject to a wide range of
uncertainty. Nevertheless, they indicate the magnitude of the challenges that lie ahead for
the Chinese labour market.
186
OECD (2005)
187
See Ianchovina and Martin (2005), Carter and alii (2005). The latter estimate that WTO membership
(with reform of the labour market) could entail a 25-50% decline in the agricultural labour force.
188
IMF (2002)
117
01_2006_4142_txt_EN.indd 117 12-07-2007 10:43:42
10.4. Labour market reforms
Given the pressures on the labour market, the government has been strengthening the
social safety net outside the reemployment centres for urban workers. An unemployment
insurance fund has been established, funded by mandatory contributions from employers
and employees. Large regional disparities however exist, especially in rural area, where
the insurance is only on a voluntary basis. More steps are needed to cover a larger part of
the population (rural migrants, in particular) and to build a modern public employment
system.
189
To control migration, China had established in the mid-50s a system of household
registration requirements (hukou). An urban hukou was needed to stay in cities and gain
access to city services such as education, health and social security. Moreover, urban
enterprises were restricted from recruiting labour from other provinces, thus hampering
the development of a national labour market. Moves to relax the hukou system were
initiated in the 1990s. However barriers to internal migration still exist, e.g. in the form
of fees on rural migration movements and prohibitions on rural migrants working in
certain sectors, which effectively block a national labour market.
Box 10-1: Hukou: a system of registration in progress
The current hukou registration system was designed in the early 1950s. Following a devastating famine in
the 1960s, the government made it stricter by limiting the mobility of the population, notably the
population flow from rural to urban areas.
One reason for limiting urbanisation was that the government considered farmers as an important resource
for developing heavy industries. Accordingly, the government needed to tie farmers to the land so as to
provide cheap agricultural products to the industrial sector. The registration system therefore tried to limit
the number of subsidised urban residents.
190
While this contributed to industrial development, it made it all
but impossible for farmers and rural workers to change residence.
Rural residents have since 1986 been allowed to purchase the right to reside in urban areas. The hukou
system has since then been further relaxed, especially as regards medium-sized towns. Even so, the fear of
migration has led some cities to return to stricter rules.
191
Moreover, in spite of reforms, the hukou system
continues to impose a cost on migration. First, migrants must pay fees for temporary residence and/or
doing business in urban areas. Second, migrants without permits do not have access to housing and health
care benefits. Third, with a view to favouring the urban unemployed, rural workers with permits
nevertheless face restrictions as to the job categories they can work in. Moreover, current regulations
stipulate that urban firms cannot recruit labour from another province unless they can show that particular
skills are in short supply.
192
In practice, though, cross-province recruitment exists, especially in big cities.
Overall, the hukou system binds a large labour surplus in the agricultural sector. It has also contributed to a
segmented labour market between rural and urban workers. The application of these restrictions in an
economy characterised by large urban-rural income differentials has contributed to a large floating¨
population, i.e. persons residing in cities without resident permits. The size of this population is estimated
at anywhere between 90 and 150 million, i.e. 13%-21% of the labour force.
189
Reuterswärd (2005)
190
Carter (1997).
191
Carter and alii (2004).
192
OECD (2002)
118
01_2006_4142_txt_EN.indd 118 12-07-2007 10:43:43
The fragmented labour market comes at an economic cost. Accordingly, relaxation would bring economic
benefits. Some studies suggest that these could be significant. In a recent paper, Ianchovina and Martin
argue that abolishing the barriers to labour mobility would strengthen a process already unleashed by WTO
accession, i.e. the flow of rural, former farm workers migrating to the cities. In general, a more mobile
workforce would also do something to help reduce the large income differences between rural and urban
areas.
Figure 10-3: Migration
5%
6%
7%
8%
9%
10%
11%
12%
13%
14%
1997 1998 1999 200 2001 2002 2003
20
30
40
50
60
70
80
90
100
% of active
population
Thousands
Source : Betcherman (2004),
10.5. Conclusion
To address labour market pressures, the Chinese government should foster job growth in
the private sector, which has been the main source of job growth in recent years.
Removing the numerous barriers to growth that are still faced by private and public
firms, as detailed in the previous sections of the report, is therefore a crucial priority.
In addition, although China has gradually moved toward marketisation of its labour
market, especially in the non-state sector, further reforms in the labour market are
needed, with greater flexibility in hiring and firing of labour, more labour mobility
geographically and across sectors, enhanced worker skills, greater transparency of the
labour market and stronger unemployment insurance schemes.
119
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11. ADDRESSING THE INCREASE IN INEQUALITY
China has since the late 1970s enjoyed very high levels of economic growth, as this
report has detailed. This has undoubtedly helped to lift many people out of poverty (how
many, how much depends on the definition of poverty, see more below). However, while
society as a whole has certainly become much richer, the rapid economic growth has not
benefited everybody equally. Instead, inequality of economic outcomes has increased
rapidly since the mid-1980s. From a fairly egalitarian - if poor - society, China has
rapidly turned into a society characterised by fairly large disparities in income
distribution, be they between persons, sectors or regions.
The reasons for the emergence of inequality on an unprecedented scale are manifold.
While initial reforms in the early 1980s benefited the countryside, especially with the
reopening of rural markets, reforms during the 1990s in the form of economic free trade
zones and the like have primarily led to growth in the coastal zones, where China`s
secondary and tertiary sectors are predominantly located. However, inequality is further
compounded by institutions. China is a segmented economy. Therefore, the kind of
forces which would normally have contributed towards evening out income differences
have been significantly reduced. For example, as outlined above, rural workers are
discouraged from moving into towns and accordingly have difficulties exploiting
economic opportunities.
Moreover, China`s welfare
systems are rudimentary and do
not redistribute resources to a
significant extent.
Moreover, China`s system of
intergovernmental fiscal
relations - reformed in 1994
with the aim of increasing tax
revenues and channelling more
of these to the central
government - perpetuates these
differences. While local
authorities have taxing powers,
most of the revenue is
transferred to the centre and then
sent back according to certain
rules-based criteria. However,
these transfers are not designed
to redistribute income. On the contrary, they go predominantly to the richer regions. As a
result, while local governments have seen their expenditure mandates effectively
increase, poorer regions are finding it increasingly difficult to find sufficient resources.
Unfortunately, by acting more like a clearing house, the central government has little
wherewithal to even out regional revenue differences.
The authorities are trying to put in place institutions aimed at addressing inequality while
not undermining economic growth. This may be crucial. The open-door policy,
compounded by the 1990s slogan of some get rich first¨, has embraced capitalism but
remains wedded to egalitarianism. It remains to be seen whether this system can sustain
support should some parts of the country and some individuals seem to be more
perpetually left behind.
Figure 11-1: Poverty headcount ratio at $1 and
$2 a day
PPP, % of population
0
10
20
30
40
50
60
70
80
1987 1990 1993 1996 1999 2001
%of populat ion
$1 a day
$2 a day
Source: World Bank (2005).
120
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11.1. Increasing disparities in economic outcomes
China`s rapid economic growth has significantly reduced the number of people living in
absolute poverty.
193
As documented by the World Bank Development Indicators, the
proportion of the population living on less than US$1 per day has decreased from more
than 30% in 1990 to 14% in 2002. Even so, these figures suggest that a sizeable part of
the population remains poor.
While the increase in living standards associated with this growth has managed to
significantly dent poverty, researchers agree that growth also appears to have been
associated with increases in income inequality.
194
Measuring income inequality is notoriously complex.
195
Results should therefore be
interpreted with care. The following figure suggests that while inequality in China is
higher than in e.g. Russia, India and Turkey, it still lags behind countries that for long
have been plagued by high levels of unequal income distribution, such as Brazil and
South Africa.
Figure 11-2: Inequality in China compared to other developing countries
International levels of the Gini coefficient
0.00
0.10
0.20
0.30
0.40
0.50
0.60
0.70
Russia³ India¹ Indonesia³ Turkey¹ Thailand China² Mexico¹ Chile¹ South
Af rica¹
Brazil²
Note: The Gini coefficient measures the degree of inequality. Its value is between 0 and 1; 0 indicating perfect equality.
Source: World Bank (2005).
Even so, while experts disagree on the level of inequality in today`s China, all surveys
show that inequality has increased at a remarkable speed since the process of opening up
the Chinese economy started in 1978. This illustrates how quickly China has gone from
being a fairly egalitarian society - albeit at very low and decreasing levels of wealth - to
a society characterised by rapidly growing, but unevenly distributed wealth.
193
Li & Yi (2005).
194
See e.g. Benjamin et al (2005).
195
Domestically, the quality of data may not be high, as raw data may not be accessible or data may have
too high a level of aggregation. As for country-to-country comparisons, definitions and measures of
income as well as coverage over time may not be comparable. See OECD (2004) for further details.
121
01_2006_4142_txt_EN.indd 121 12-07-2007 10:43:44
Figure 11-3: Inequality within China
Rural, urban and national Gini coefficients
0.00
0.05
0.10
0.15
0.20
0.25
0.30
0.35
0.40
0.45
0.50
1978 1982 1985 1988 1991 1994 1997 2000
Rural
Urban
Overall
Sources: Wenxiu (2004) and for 2001 overall rate, World Bank (2005).
However, some research suggests that figures measuring overall inequality need to be
nuanced, suggesting that the gap between rural and urban incomes may not be as
dramatic. A survey of 100 cities between 1988 and 1993 found that those cities where
trade to GDP has grown more have seen decreases in inequality between its urban and
neighbouring rural areas.
196
Moreover, the above figure shows that inequality is much higher within the rural regions
than within urban regions. Rural inequality increases at about the same speed as urban
inequality, implying no catching up. Inequality within villages has increased, possibly
due to differing access to education but especially differences of access to non-farm
opportunities. With the latter comes wage income. Moreover, as agricultural prices
closely follow global market conditions, the fall over recent decades has further
depressed rural incomes. This cyclical income fall could become permanent should farm
productivity increase.
197
The pressure on agricultural income levels is likely to be further
accentuated should China continue the process of revaluing its exchange rate.
198
11.2. Reasons for increases in disparities
There are several reasons why the rapid growth in China over recent decades has been
associated with increased income inequality. Like many other developing countries
experiencing rapid development, growth is unevenly balanced, favouring some regions,
sectors and individuals more than others. These differences are partly reform induced, as
reforms have been oriented towards coastal regions and policy has primarily focused on
rural needs. However, disparities are also exacerbated by unreformed institutions that
produce suboptimal outcomes in today`s more market-oriented environment. The
imbalances can also be explained by historical factors and past policy decisions. For
example, regions have different resource assets, with some regions better equipped to

196
Wei & Wu (2001).
197
Benjamin et al (2005).
198
Blanchard & Giavazzi (2005).
122
01_2006_4142_txt_EN.indd 122 12-07-2007 10:43:44
profit from current patterns of economic growth. For example, while the East is not well
endowed with natural resources, it has a favourable location, good transport
infrastructure and a bigger pool of educated labour. It is in these regions that the first
Free Special Economic Zones were created. The Western regions are on paper well
endowed with natural resources, but their exploitation is hampered by unfavourable
geographic conditions (e.g. little arable land) and long distances, bad infrastructure and
accordingly high transport costs.
199
As regards rural income, traditional modes of
organisation in the agricultural sector have suppressed agricultural income over
centuries. Communist pricing policies compounded the income differences between rural
and urban areas, as industrial products in urban areas carried higher prices. While initial
reforms in the early 1980s favoured the rural areas - by allowing diversification of
income streams and arranging for a fairer distribution of land - reforms have since
primarily favoured the coastal regions.
However, income disparities are also compounded by current policies.
200
Daa/ ecanam/c s(rac(ares. Rural and urban goods and labour markets remain
separated. The registered permanent residence system - hukou¨ - makes it difficult
for labour to circulate freely (cf above). A worker moving to another area loses the
right to education and health benefits and cannot buy housing, as he or she is not
allowed to register property. Accordingly, labour mobility is reduced. This
undermines the economic forces of arbitrage, makes efficient resource allocation more
difficult, and contributes towards perpetuating wage and other income disparities.
201
Pa//cv preferences. Policy has indirectly and directly favoured some regions over
others, hence making it difficult for these to compete on even grounds. The East has
been favoured since the early days of reform, both in terms of state investments and
policy discretion. The Western regions have only experienced similar levels of
freedom since the early 1990s. These differences are reflected in FDI inflows, as the
richer, more better connected Eastern regions receive the great bulk of FDI and hence
have been benefiting most from the development associated with FDI, cf chapter 1.
L/m/(ed red/s(r/ba(/an. The increasing differences have not been counterbalanced by
any policy measures such as taxation or social security. The tax system does not
redistribute, as it only covers some income streams (wage, not capital), weighs more
heavily on low income individuals and rural regions and is vulnerable to tax
avoidance and evasion. Social security (e.g. unemployment, sickness and old age
insurance) is only partially developed, has patchy coverage and is under-funded.
Social security systems are more developed in urban areas. For example, annual per
capita health care expenditure amounted to RMB 200 in Beijing in 2002. The
corresponding figure for a central province such as Hunan was RMB 20.
202
Haman cap/(a/ d/fferences. A high level of human capital carries more material
rewards in today`s China than before. However, human capital is unevenly divided
between East and West, with the former scoring higher on all levels of education (cf
above). Policy has so far focused on boosting higher education, while neglecting
199
OECD (2004), chapters 1-2.
200
See OECD (2004) for overview.
201
See Whalley and Zang (2004) for an overview of the economic effects of the hukou¨ system.
202
IMF (2004).
123
01_2006_4142_txt_EN.indd 123 12-07-2007 10:43:45
primary and secondary education. This has been particularly detrimental to rural
areas.
203
11.3. Conclusion
Without killing off the incentives for growth, it is important for China to deal with the
challenge of social cohesion. If unaddressed, the increase in income inequality and
regional disparities may slow economic transition and act as a drag on future economic
growth. If some parts of society are perpetually left behind, support for economic
openness and reforms may erode. However, in view of China`s rapid economic growth,
resources should be available to ensure more effective support for those who lag behind,
be it people or regions.
203
OECD (2004), chapter 6.
124
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12. ADDRESSING ENVIRONMENTAL CHALLENGES
China`s leaders are very well aware of the need for a more balanced form of
development that takes into account protection of the environment and national
resources. The 11
th
five-year Plan (2006-2010) signals a notable shift from growth¨ to
sustainable development¨, balancing the needs of people and the sustainability of the
environment. Beyond the objective of doubling GDP per capita in 2010 compared to
2000, the other quantitative objective is to reduce energy consumption per unit in 2010
by about 20% compared to 2005. The objective is for China to choose a development
path that economises on resources, using a 5-R¨ policy: Rethink, Reduce, Re-use,
Recycle and Repair.
12.1. Pollution control
The quality of the environment remains a serious cause for concern in China. There has
been progress in introducing pollution control. As a result, emissions of polluting gases
rose less rapidly than energy consumption, which in turn has risen less rapidly than GDP.
However, the level of both water and air pollution remains high. Several of the most
polluted cities in the world are in China. Air pollution is mainly caused by the use of
coal with a high sulphur content. Almost all of the nation`s rivers are considered
polluted to some degree. Half of the population lacks access to clean water. Most of the
urban water bodies are severely polluted. Water scarcity is an issue in northern China,
requiring large-scale diversion of river water, while the south faces flood risks.
China`s leaders are increasingly paying attention to the country`s environmental
problems. The State Environmental Protection Administration (SEPA) was officially
upgraded to a ministry-level agency. New legislation, introduced in 2003, has
strengthened the use of financial penalties for the emission of air and water pollutants.
But the major challenge is the effective monitoring and enforcement of laws by local
agencies. An increasing share of the state budget is allocated to environmental
protection. Beijing in particular has invested heavily in pollution control as part of its
campaign to host the 2008 Olympic Games. China is also looking for new technological
developments to meet the environmental challenges. Finally, the PRC is a participant in
the climate change talks and other multilateral environmental negotiations.
12.2. Efficient use of national resources
China is not particularly well endowed with national resources to support its growth. For
instance, 20 years ago China was the largest oil exporter in East Asia, whereas now it is
the world`s second largest importer. In order to reduce its dependency, China is devising
a growth strategy that builds on energy-saving technology and the more efficient use of
energy. However, this will not be sufficient in the short to medium term. China`s access
to foreign resources is necessary for continued economic growth. So state-controlled
companies are being urged to secure exploration and supply agreements with countries
producing oil, gas and other resources. For this, China is increasingly turning to resource-
rich developing countries (e.g. coal from the Philippines, oil from Angola, Sudan and
Ecuador, natural gas from Canada and Australia), raising important geopolitical
concerns, as already discussed earlier.
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13. ADAPTING CHINA`S POLITICAL AND LEGAL INSTITUTIONS TO A TRANSFORMED
SOCIETY
While the restructuring of the Chinese economy has been fairly rapid, China`s political
reforms have been more sluggish. So far the political reform effort has essentially aimed
at adapting the existing political system to a new socio-economic environment by
perfecting and reinforcing one-party rule, but not challenging it. The Chinese Communist
Party (CCP) retains its grip on power, including its control of the military, and the
leadership persistently argues that political stability is of the utmost importance for the
country.
204
There are two outstanding questions. First, can China in the longer run sustain economic
development without restructuring its political system? In other words, can China`s
experiment of embracing the market and maintaining an authoritarian political system
coexist for long? Second, how should China proceed towards a more democratic system
without risking the chaos and instability everyone fears in China, in the neighbouring
countries and further afield? These are important questions for a country like China that
needs stability for its continued economic growth and, having learned the lessons of its
recent history of turbulence and disorder, values political stability in its own right.
The White Paper Building Political Democracy in China¨, issued in October 2005 by
the State Council, can be viewed as China`s response to Western criticisms over the pace
of political reforms in the country. While it argues the case for China`s type of socialist
democracy¨ and for the continued dominance of the CCP, it does not entirely reject the
need for political reforms. The State Council refers to a number of areas where further
progress should be achieved, such as 1) more political participation of citizens, 2) a better
system of law enforcement, 3) continuation of the fight against corruption and excessive
bureaucracy, 4) enhanced supervision over the use of power, and 5) a better public
awareness of legal rights and obligations. The State Council further acknowledges that it
will take time to achieve reforms in these areas: there is still a long way to go in China's
building of political democracy, which will be a historical process of continuous
improvement and development.¨ That position reflects the dominant perception among
China`s policymakers and influential thinkers. Democratising too rapidly - as Gorbachev
did in the Soviet Union - would endanger the country`s stability and growth.
13.1. A changing society
China is no longer a homogeneous authoritarian country. Chinese society has been going
through profound changes. A 2005 GlobalScan report found that China was the country
that showed the highest level of support for the free enterprise system and the free
economy, with 74% of the respondents agreeing that it is the best system.
205
The
Chinese people hold very high expectations about benefiting from their country`s on-
going economic expansion. A global study by the Pew Global Attitude Project shows that
204
President Jinag Zemin in an interview with the New York Times in August 2001 declared: I can tell
you with certainty: should you apply the parliamentary democracy of the Western world, the only
result will be that 1.2 billion Chinese people will not have enough food to eat. The result will be great
chaos.. Cited by YingMa, China`s America Problem, Policy Review, 111, February/March 2002
205
In China the survey was conducted in urban areas: Beijing, Chengdu, Guangzou, Hangzhou, Shanghai,
Shenyang, Wuhan, Xi`an and Zhengzou representing 36% of the total population in urban China.
Interestingly, the same report found that France was the one country where most (50%) disagreed with
the proposition; only 36% agreed.
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01_2006_4142_txt_EN.indd 126 12-07-2007 10:43:45
the Chinese have, in recent years, been happier than they have ever been in terms of
improved living standards and are the most optimistic about their future, 72% of the
respondents expressing satisfaction with their national conditions.
13.1.1. Emergence of a middle-class
More than two decades of economic reforms have led to the emergence of a new social
group which enjoys higher living standards than the ordinary worker, owns properties
such as cars and houses (by the early 2000s about 70% of China`s urban households
owned their home) but is not yet part of the richest strata. The Blue Book of Chinese
Society¨, an annual survey of China`s social features published by the Chinese Academy
of Social Sciences (CASS), shows that this middle-class is growing but it is not yet well
formed.
Table 13-1: Self-identification measure
Social Stratum Share of respondents
Upper 1.3%
Upper-middle 7.1%
Middle 38.4%
Lower-middle 23.2%
Lower 20.8%
Unclear 1.4%
No response 7.8%
(Source: Joseph Fewsmith, Continuing Pressure on Social Order, China Leadership Monitor, Issue 10,
Spring 2004)
Li Chunling, a CASS sociologist, has tried to define China`s middle-class on the basis of
four main criteria: income, expenditure, profession and self-identification.
206
The self-
identification criteria - people are asked how they view their own social standing -
shows that 46.8% of the respondents identify themselves as middle-class or higher.
According to less subjective criteria, only 4.1% of the population fits all the four criteria.
Furthermore according to Li`s findings the main features of the rising middle-class are
that they are predominantly young (57% under 41), urban (64.6%) and well-educated
(51.1% with more than high school education). Moreover, only 10% are Party cadres.
Finally, one-sixth are enterprise managers, another sixth private enterprise owners, one-
fifth specialists and technicians, and one-third office workers.
With the higher living standards come new interests to be defended, in particular as
homeowners. That may lead to clashes with the government or other elites, as violations
of homeowners` rights by the government or business actors are common. However it
appears that it does not represent a new threat for Party rule and China`s political order.
A study of two significant cases of homeowners` protests subsequent to violations of
their rights found that homeowners have limited political ambition and ability to take
action.
207
The middle-class`s first choice of action when resisting the State is to engage
rather than to confront and to advance its interests without threatening the political order.

206
Li Chunling`s work cited by Joseph Fewsmith in Continuing Pressure on Social Order, China
Leadership Monitor, Issue 10, Spring 2004
207
Yong Shun Cai, China's Moderate Middle-Class. The Case of Homeowners' Resistance. Asian
Survey, Vol.45, Issue 5, 2005, pp 777-799
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According to the same study, the moderate nature of the middle-class is determined by its
interests being connected to the existing political order in one way or another.
13.1.2. The young urban entrepreneurs
With the boom of private enterprises during the last decade has emerged a young and
well-educated urban economic elite. Some of the leading Chinese companies - such as
SINOPEC, China`s second largest oil company; China Mobile, the largest Telecom firm;
China Construction bank, the second largest commercial bank; or Shanghai Baosteel
group, the largest steel producer - have CEOs who are younger than 40. Many of these
majored in engineering, a few received their degree from overseas, and several received
their MBAs from the China-Europe International Business School (CEIBS) established
in 1994 by the Chinese government and the European Union. According to several
observers CEIBS has actually become a cradle for China`s CEOs¨.
The members of this young economic elite are increasingly being tempted into politics.
Nine hundred private entrepreneurs nationwide participate in People`s Congresses and
30 000 participate at various levels in People`s Political Consultative Conferences
(CPPCCS). This new elite is more than welcome by the CCP. For the first time ever,
entrepreneurs of large companies and banks attended as a distinct group the 16
th
national
congress of the CCP. The Central Enterprise Work commission and the Central Financial
Work commission had their own delegations, and 17 representatives of the
entrepreneurial class became members of the Presidium of the Party Congress, while 24
entrepreneurs from large SOEs, collective firms, joint ventures and commercial banks
were selected to serve on the 356-member 16
th
Central Committee as full or alternate
members.
208
A 2001 national survey found that 29.9% of private entrepreneurs were
Party members (against 19.8% in 2000) and 90% of these joined the CCP before
becoming private entrepreneurs.
209
13.1.3. The return of foreign-educated Chinese
One of China`s greatest strengths is without any doubt its population`s hunger for
education. In 1978 Deng Xiaoping decided to send students and scholars to study abroad.
In 1992 the government drafted guidelines recommending support for students wanting
to go abroad, encouraging their return and allowing them to come and go freely.
China`s growing involvement in the international community has created an increased
demand for in-depth research and analysis to provide the Chinese leaders with informed
policy recommendations. It is not surprising therefore that the vast majority of the
foreign-educated Chinese who returned to China now work in the fields of education,
research, science and technology. In 2005 the Ministry of Education reported that about
60% of all the highest university principals are foreign educated.
210
Moreover, a large
208
More recently the appointment of Miao Yu of Dongfeng Motor Corporation to become Party secretary
of Wuhan has been widely reported in the Chinese media.
209
All the figures mentioned here are from Cheng Li, The Rise of China's Yuppie Corps . Top CEOs to
Watch, China Leadership Monitor, Issue 14, Spring 2005
210
The Minister for education, Zhou Ji, is himself a foreign-educated Chinese. All the faculty members of
the Beida Centre of China Economic Research, which regularly advises top Chinese leaders, have
studied abroad, essentially in the United States, and these US-educated economists have largely
redesigned the curriculum and research methods in economics and management in line with the
American model, in particular the Chicago model.¨
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number of think tanks are led by foreign-educated scholars and several analysts have
noted an interesting and dynamic interaction between national power and interests and
transnational knowledge.¨
211
A significant number of returnees are also involved in
foreign trade and foreign affairs, banking, and finance. In Shanghai some 3 000 private
enterprises were established by returnees. Nevertheless, on the whole China`s political
system is not very open to returnees. They play a political role only in the few fields
mentioned above.
212
The share of returnees at ministerial and provincial levels remains
fairly low; 13.6% among ministerial leaders and only 5.8% at provincial level are
educated abroad.
13.1.4. The emergence of a new political generation
In China a political generation means a group of people born during a period of fifteen
years and who have experienced the same major historical events during their formative
years. The first generation under Mao is known as the Long March generation¨, the
second under Deng is the Anti-Japanese war generation¨, the third under Jiang, the
Socialist transformation generation¨, and the fourth generation the Cultural revolution
generation.¨
The fifth generation of future leaders was born between 1957 and 1972. They have lived
through a time of unprecedented economic and social transformation. Some of them have
become strong market economy defenders; others harsh critics of capitalism. They are
generally more educated than their predecessors and while the third and fourth
generations` leaders were largely engineers by training, the leaders-in-being have studied
economics, politics and law. They have experienced Tiananmen and they may fear a
Tiananmen-like violent clash as the fourth generation fears a recurrence of the Cultural
Revolution. They grew up in a more open and pluralistic society but they can hold strong
nationalist views. All the members of the so-called Say No Club - the authors of a book
series called China Can Say No, which expressed strong Chinese nationalism views -
were born in the late 1950s-1960s.
The fifth generation is likely to be the most diversified elite generation in PRC history,
not only in terms of views and values but also in terms of education and professional
background. Some of the frontrunners of this new generation represent the rising
entrepreneurs and the foreign-educated ones - the self-proclaimed best and brightest¨ -
others come from the local elites. They are Hu`s main protégés, the so-called tuanpai
who are starting to emerge in State Council ministries and top provincial leadership
positions. Like Hu, they advanced their career through the Chinese Communist Youth
League and received their leadership experience in inland provinces. They do not have
any practice in foreign trade, finance or banking but they have a substantial experience in
rural administration and Party organisation and propaganda. They are trustworthy
supporters of Hu`s harmonious society¨ policy and effective agents for promoting it in
the inland regions. By contrast the rising economic elite and the foreign-educated
211
Some of the most prominent aides to Hu Jintao have studied abroad. Xia Yong, Director of the State
Bureau of Secrecy, studied at Harvard University (U.S.), Yu Keping, Deputy Director of the Central
Bureau of the CCP was at Duke University (U.S.) then at the Freie Universität in Germany, and Wang
Jisi, Director of the Institute of International Strategic Studies at the Central Party School was at
Oxford University, then at Berkeley and University of Michigan in the United States.
212
Although so far most of the foreign-trained Chinese have graduated in engineering, economics and
management, a new trend has been emerging in recent years with many officials sent by central and
local governments to study abroad public administration, law and international affairs.
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01_2006_4142_txt_EN.indd 129 12-07-2007 10:43:47
Chinese come mostly from the coastal region and have never or rarely had any leadership
experience in local governments. Over the past decade provincial leadership posts have
opened the way to national leadership, but that may change.
What comes out of such a highly contrasted, almost dichotomous, new generation
remains to be seen. It may lead to a more representative and pluralistic political system if
complementarity overcomes divergence, or it could lead to tensions and power struggles.
13.2. A Communist Party in search of legitimacy
Polls conducted by the official national trade union in 1996 found that only 15% of the
workers surveyed regarded communism as their highest ideal¨ while 70% said that their
top priority was to pursue individual happiness.
213
These results are in line with the
GlobalScan survey referred to above. Obviously the Party`s traditional ideology is no
longer convincing, requiring the need for a new legitimacy.
13.2.1. Nationalism
Nationalism is the sole ideology glue that holds the People`s Republic together and
keeps the CCP government in power. Since the Chinese Communist Party is no longer
communist, it must be even more Chinese.¨
214
The Chinese leaders use nationalism to
hold the country together. In the aftermath of Tiananmen, CCP leaders promptly
presented themselves as the defenders of national pride and interests by resisting Western
sanctions. From joining the WTO to standing firm against Taiwan`s dalliance with
independence or China being selected to host the Olympics in 2008, a number of events
have helped feed this nationalist trend. The party redefined itself as a Party of the
people¨, becoming the vanguard of the Chinese nation and the Chinese people, and not
only of the Chinese workers.
215
The CCP has been transformed from a revolutionary
party of the proletariat into a ruling party for the whole of the Chinese people.¨
216
Moderate nationalism is supposed to foster political stability conducive to the continued
economic modernisation on which the Party`s popular acceptance is ultimately based.
While pragmatic nationalism¨ may have given a new legitimacy to the CCP it could
equally create expectations that the Party may not be able or willing to fulfil. Nationalism
is a double-edged sword and may unleash forces that the CCP cannot control, thus in the
end potentially undermining the Party`s standing.
213
A survey of 818 migrant workers in Beijing in 1997-1998, although a highly selective sample,
revealed that the prevailing image of the Party was the one of a self-serving elite¨ widely corrupted.
Minxin Pei, ibid
214
Thomas J. Christensen, Chinese Realpolitik, Foreign Affairs Vol. 72, n°5, September / October 1996
215
Looking at the correlation between economic reform and delayed democracy in China, Callagher
(2002) shows how the Chinese regime has retained its legitimacy by reformulating the debate in 1997
over the privatisation of a large number of SOEs into a debate over Chinese national industry vs.
foreign-invested industry. Privatisation was presented as a national interest once China had to defend
the survival of its industry against competition from foreign industry. The socialist perspective and its
core principles such as state ownership, working class as the master class¨, and guaranteed
employment have been replaced by a nationalist perspective and the ability of national industry to
compete with foreign industry. Mary E. Gallagher, Reform and Openness , Why China's Economic
Reforms Have Delayed Democracy, World Politics , 54, April 2002
216
Gang Lin, Leadership Transition. Intra-party Democracy and Institutions Building In China, Asian
Survey, Vol.44, 2, March/April 2004, pp255-275
130
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13.2.2. Inner party democracy
After the traumatic time of the Cultural Revolution and the ensuing social chaos, the
leadership publicly acknowledged that some political reforms were necessary. In a
speech delivered in August 1980 - On the reform of the System of the Party and State
Leadership¨ - Deng Xiaoping called for an end to the over-concentration of power in
order to avoid arbitrary rule, a separation of Party and government responsibilities, and a
new system of leadership succession based on meritocracy.
217
Some progress has been
made since then to enhance the Party`s governing ability, and there is clearly a trend
towards political institutionalisation that restrains individual powers.
A two-term limit system (terms of five years each) and a mandatory retirement age
(65) have been in place since 1985. For the national party leaders no formal retirement
age rule was specified. In 1997 an informal age limit of 70 was applied to the election
of Politburo members. At the 16
th
Party Congress in 2002 when Hu became new Party
general secretary, all incumbent members of the Politburo over 70 years old retired
without exception.
Some electoral mechanisms have been introduced within the Party for elections to the
Central Committee. In 1982 delegates were allowed to add and delete names to and
from the list of nominees for the Central Committee provided by the leadership. In
1987 new election rules for the Central Committee required that the number of
candidates must exceed the number of seats by five percent. This share remains the
same today.
Improvements in policy-making mechanisms aimed at overcoming the problem of
concentration of power conducive to corruption have been tested in some places. They
include decision-sharing, with important decisions left to the full membership of these
Party committees rather than solely to the standing members or Secretaries.
There is a clear interest in the professionalisation of the party leaders` management
system so as to enhance the Party bureaucracy`s efficiency and impartiality.
Public sector corruption has received much attention in recent years. In 2004, the Party
intensified its anti-corruption campaign by publishing the Regulations of Internal
Supervision of the CCP and Disciplinary Penalties of the CCP. However the problem
continues. There are new worrying tendencies, such as an increased number of principals
and young officials involved in corruption. At the same time, corruption is tending to go
undiscovered longer.
218
13.2.3. Grassroots democracy
When the People`s Communes were disbanded in the late 1970s and early 1980s the
Chinese farmers enjoyed the benefits of decollectivisation but were confronted with new
difficulties such as shrinking incomes. Moreover, serious leadership problems emerged
when leaders left their positions for more lucrative ones or, on the other hand, when there
was an excess of power exercised by local emperors-strong men¨. Soon rural China
217
Cited by Gunter Schubert, Reforming Authoritarianism in Contemporary China . Reflections on Pan
Wei's Consultative Rule of Law Regime, Asien 94, January 2005
218
Wen Shengtan of the Supreme People`s Court.
131
01_2006_4142_txt_EN.indd 131 12-07-2007 10:43:47
slipped into a state of potential crisis. This triggered attempts to restore order. The
response given by some was to introduce elections.
219
The Organic Law of Village Committee adopted in 1987 stipulates that the chairman,
vice-chairmen and members of village committees should be directly elected by the
residents of the village. The Law started to be implemented in 1989. Over time the
Ministry for Civil Affairs has introduced four criteria for democratic elections at village
level: (i) the chairman, vice-chairmen and members of village committees must be
directly elected by the villagers themselves; (ii) the number of candidates must be greater
than the number of positions (competitive elections); (iii) voting must be by secret ballot;
and (iv) the winning candidate must receive more than half of the votes.
It is still not easy to draw any overall conclusion from the experiment of elections at
village level. There are 800 million people living in China`s rural areas, with nearly a
million villages, and the overall picture is very diverse. In some areas the elections are
held properly, while other areas continue to experience problems such as corruption, and
violations of the Organic Law. Foreign observers have witnessed elections only in a few
villages. Nevertheless, on the whole it seems that when elections are held in strict
accordance with the four criteria set by the Ministry of Civil Affairs they are followed by
positive effects: those elected are younger, better educated and more entrepreneurial as
well. While a majority of those elected are Party members a significant minority are not.
Thus the village elections may become a recruiting tool bringing younger, more
entrepreneurial and more popular leaders into the Party and subsequently enhancing the
Party`s legitimacy. According to the law, People`s Congresses below the county level
should also be elected directly but since the nomination process remains dominated by
higher level authorities the experiment has not been conclusive so far.
Other political reforms have been experienced at grassroots level in some areas, notably
prosperous ones such as Zeguo in Wenling municipality alongside Zhejiong Province`s
South-eastern coast. Democratic consultations on public policy issues have been
organised since 1996 in order to enhance public participation in decision-making.
220
Citizens and Party representatives discuss important public issues, raise questions,
express views and opinions. The sessions go into recess, during which the leadership
discusses the proposals raised then announce the result to the citizens. Such consultations
enhance both political legitimacy and social stability, and above all they do not challenge
the rule of the Party.
13.2.4. China's civil society
In the wake of the social transformation unleashed by economic liberalisation, the
government has recognised the need for civil society to assist in managing the
consequences. The State has accordingly gradually transferred some of its functions to
civil society organisations. For the optimists this is a signal that in the end the emerging
civil society will be conducive to democracy. However, pessimists can argue that the
219
This response did not come necessarily from the more reform-minded leaders. Premier Zhao Ziyang,
who was considered as one of the most advanced Chinese reformers, was opposed to elections at
village level. He feared losing control over rural reforms and would have preferred to introduce
political reforms in urban areas. Actually the debate was not about the advantages of democracy but
whether political reforms would fuel or hold back chaos.
220
Joseph Fewsmith, Taizhou Area Explores Ways To Improve Local Governance, China Leadership
Monitor, Issue 15, Summer 2005
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01_2006_4142_txt_EN.indd 132 12-07-2007 10:43:48
State has also developed a number of strict regulations to control the development and
activities of those organisations.
The civil society organisations must register and they must have a sponsor approved by
the government which will submit the registration request to the Ministry of Civil
Affairs. The sponsor is legally responsible for any possible wrongdoings by the
organisations and the law does not offer any incentives to potential sponsors. The
obligation to renew the registration annually provides a useful tool of control. Civil
society organisations are restricted in their ability to establish sub-divisions and branches,
and the regulations forbid the establishment of two civil society organisations with a
similar mandate in the same administrative region.
The term NGOs is often used to refer to foreign NGOs rather than to any Chinese
organisations. The Chinese organisations closer to the Western concept of NGOs are (i)
the social organisations (Shehui tuanti), most of which operate at local or county levels;
(ii) the non-governmental and non-commercial organisations (minban feiqiye danwei), a
large number of which deal with education and health issues; and (iii) the foundations
promoting the development of scientific research, culture, education and social welfare.
The environmental civil society organisations are of special interest and importance as
they fill a critical gap in the State`s ability to address effectively the crucial environment
issue. Therefore the Chinese authorities tend to adopt a generally positive attitude
towards whichever organisations happen to work closely with the State Environment
Protection Administration (SEPA), as they did for instance on a campaign about energy
efficiency. The SEPA Vice-Director, Pan Yue, announced recently that SEPA will help
to establish an environmental organisations cooperation network and provide
professional training to small grassroots groups.
A survey of 22 environmental civil society organisations has shown that some of them
did not experience state control and five were not registered at all and nonetheless
conducted their activities openly without being bothered by the authorities.
221
The
environment is indeed an area where the organisations have been allowed to work with
limited political control, which is why some observers consider that this has created the
first independent grassroots movement that has been tolerated sine the CCP came to
power in 1949.¨
222
On the other hand, it appears that the environmental organisations are
good at handling their relative freedom, including by censoring themselves so that their
activities do not provoke repressive state reactions.
The chambers of commerce offer another interesting case in point of the evolution of
China`s civil society and its interaction with State authority. They illustrate China`s
ability to develop new forms of administration adapted to the country's evolving socio-
economic conditions and the Chinese leaders` capacity to accommodate to these new
institutions. As there is a Subnan (southern Jiangsu Province) model of collective
enterprises and a Guangdong model of enterprises with foreign capital, so there is a
Wenzhou model of chambers of commerce and trade associations that has attracted much
attention. Wenzhou, situated in the prosperous Zhejiang province, experimented in the
1980s-1990s with an impressive but chaotic development which ultimately led to profit
erosion, in particular in the shoe industry, which acquired a reputation for low-quality
221
U.S. Congressional Executive Commission on China, Environmental NGOs in China . Encouraging
Action and Addressing Public Grievances, Statement of Jiang Ru, February 7, 2005
222
Oxford Analytica Brief, China . Harbin Emergency, November 28, 2005
133
01_2006_4142_txt_EN.indd 133 12-07-2007 10:43:48
production. Reacting to this worsening situation, the shoe industry was the first to
organise itself and to think in terms of quality production and control improvements, and
to develop a core of skilful workers. A Lucheng District Shoe Industry Association was
established. The government, in cooperation with the new association, promulgated the
Management Regulations on the Rectification of Quality of the Lucheng District Shoe
Industry" and the provisional regulations on After Sales Service of the Shoe Industry.¨
From there, chambers of commerce and trade associations grew quickly. In August 2002
there were 104 such non-governmental associations at city level and 321 at county and
district levels.
The chambers of commerce and trade associations have always worked in close
cooperation with the state through the Alliance of Industry and Commerce. However, the
state`s involvement in these associations` internal affairs has progressively diminished,
and while the state still appoints a few chairmen, 77% of those associations report that
they freely elect their chairman in accordance with their own rules. Observers note a
growing trust on the government side towards these associations and in parallel an
understanding on the side of the associations that they will be better off if they promote
their business interests without threatening the ultimate authority of the party.¨
Undoubtedly these different reforms towards better governance have helped enhance the
Party`s accountability and legitimacy, and even develop among the Chinese people a
certain democratic consciousness¨; but they fall short of showing the Party really
adjusting to growing socio-economic forces.
13.3. A dual approach to society
The administration is keen on addressing the issue of social unrest that challenges the
country`s stability and the Party`s rule. The number of incidents has increased steadily
over the last decade.
223
If the number of incidents is on the rise, it appears that the
demonstrations are also better organised and are increasingly tending to turn violent.
However, it is important to stress that so far there is little sign that the protesters are
turning against the Chinese government per se. In responding to these protests, the
government is sometimes more open, sometimes more repressive.
13.3.1. The caring approach
Since they gained power in 2002 both Hu and Wen have presented themselves as caring
rulers. Many of their slogans are about putting people first¨, running the administration
for the sake of the people¨, and seeking harmony in the midst of differences.¨ They
have indeed paid more attention and devoted more resources than any other previous
administration to people who have got "left behind", such as retired workers or peasants.
Some important policy changes have already been made to improve social harmony. Tax
burdens on farmers have been reduced, and in late 2005 Hu and Wen announced the
abolition of all rural taxes by the end of 2006. The State Council has ordered business
firms and local governments to pay their debts to migrant workers, and over the next ten
years the central government plans to provide professional training to unemployed
223
According to the definition given by China`s Ministry of Public Security mass incidents refer to
public order disturbances, obstructions of justice, gathering of mobs and stirring up of trouble.¨
There were 10 000 mass incidents in 1994 and 74 000 in 2004. On 19 January 2006 the Public
Security Bureau released the figures for 2005 that show an increase by 6.6% to 87 000 mass incidents
recorded.
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01_2006_4142_txt_EN.indd 134 12-07-2007 10:43:48
migrant workers. In 2003 the State Council decided that any additional resources given
to education, health care, medicine, science and technology, and culture should in future
be primarily invested in the rural areas.
The impact of these policy initiatives has been very positive. According to a CASS
Survey conducted in 2004, 56.8% of respondents consider that the Chinese leadership
has made important progress towards improving the lives of vulnerable social groups
(against 9.2% in the 2003 survey).
224
At this stage, it is difficult to know if the growing consideration given to vulnerable
groups signals a profound change in state-society relations as argued by some Chinese
scholars. It could well be that once Hu has consolidated his power he will be favourable
to more open expressions of intellectual and societal opinions. For the time being Hu`s
priority is obviously to sustain stability in the political order at a time of leadership
transition.
13.3.2. The repressive approach
However, the Hu-Wen administration is also known for its strict control over the media
and the Internet. Moreover, there were recently disturbing signs that both central and
provincial leaders had allowed the police and the paramilitary police to use force against
demonstrators. Hu may be a follower of Mao`s dictum a spark from heaven can light up
an entire plain¨, so better to crush a single revolt before it spreads across the country.
The new amendments to petitioning regulations in effect since 1 May 2005 stipulate that
better consideration has to be given to the petitioners and that anyone who retaliates
against petitioners as well as officials who fail to carry out their duties must be punished.
On the other hand, the same regulations restrict petitioner activism.
225
Tighter control is being exercised over the media and cultural institutions. Over the last
two years, the Chinese government has launched a campaign to increase restrictions on
the flow of information. Hundreds of illegal political publications have been banned, a
licensing system for reporters not affiliated with official media outlets has been
established, and new registration requirements for websites have been imposed. In early
January 2005, the head of the Publicity department of the CCP`s central committee
signalled that controls over publishing, the Internet, and short messaging systems (SMS)
would be significantly tightened to ensure social stability. In September 2005, new
regulations were introduced on Internet news, prohibiting the distribution of uncensored
versions of e.g. a news event.
John Palfrey, executive director of the Berkman Center for Internet and Society at
Harvard Law School, considers that fear has led the Chinese government to create the
world`s most sophisticated Internet filtering regime¨, known as the Great Firewall of
China¨. Some of the world`s most famous companies have bent to Chinese demands for
restricting and controlling Internet access.
226
According to Reporters without Frontiers,

224
Cheng Li, Hu's Policy and the Tuanpai's Coming of Age, China Leadership Monitor, Issue 15,
Summer 2005
225
Human Rights Watch - World Report 2006
226
John Palfrey, OpenNet Initiative Testimony Before the U.S.-China Commission - ¨Internet Filtering in
China in 2004-2005, April 14, 2005
http://www.opennetinitiative.net/studies/china/ONI_China_Country_Study.pdf
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01_2006_4142_txt_EN.indd 135 12-07-2007 10:43:49
Cisco Systems has sold several thousand routers to enable the regime to build an online
spying system and the firm`s engineers have helped set it to spot `subversive` key words
in messages.¨ All the companies helping the Chinese authorities insist that they are
merely obeying local laws.
227
13.4. Improving the legal system
13.4.1. From rule of man to rule of law
One of the most significant challenges the West is facing in its dealings with China is the
enforceability of regulations and legal commitments. Chinese law is based on the
principle that the state has primacy: the rule of man (ren shi) as opposed to the rule of
law (fa shi). However, since the Reform Era, China has accepted the need for a legal base
offering greater legal certainty and transparency for economic activities to develop. But
as this legal framework is developing, there is still a lot of experimentation and learning
going on.
The reform of China`s legal system has been one of the most important changes in China
during the process of economic modernisation. However, the progress made in building a
modern legal system looks mixed. Indeed, over the last 25 years China has passed nearly
400 laws that have laid the foundation for a modern legal system, and (i) administrative
laws have been modernised, (ii) the criminal code has been improved, (iii) the
Constitution has been amended to include the protection of human rights and private
property rights, (iv) Chinese citizens are increasingly using the legal system to protect
their personal and property rights and they have also begun to sue local governments for
abuse of power, and finally (v) the number of lawyers has increased from a few thousand
in the early 1980s to more than 100 000 in 2002, and lawyers and judges are better
trained today than in the past.
However, China has not yet established a genuine modern legal system or rule of law.
The main weaknesses relate to a lack of judicial independence (the Court system is
controlled by the Party) and weak judicial authority (Chinese courts lack the political
authority to enforce their decisions). Other reasons are a lack of respect for the law (laws
are not enforced or are ignored by the government itself), the reluctance of the CCP to
allow real judicial constraints on the exercise of its power and, finally, judicial corruption
(in public perception the Chinese judiciary is one of the most corrupt government
institutions).
The Chinese leadership is aware that greater professionalism, independence and integrity
should be brought to the judiciary. The Second Five-Year Reform Programme for the
People`s Courts (2004-2008), issued recently by the Supreme People`s Court, goes in
that direction. It assigns some 50 goals for Court reform (revising adjudication
procedures for death penalty case is the first stated goal). However the document also
reasserts the leadership of the Party and the supervisory power of the people`s congresses
at all levels.
13.4.2. Enforcement and implementation
Weak enforcement of improved legal and regulatory frameworks has been a recurrent
theme of China`s economic reforms, ranging from enforcement of contracts, commercial
227
Jonathan Mirsky, Censoring the Internet, International Herald Tribune, 16 January 2006
136
01_2006_4142_txt_EN.indd 136 12-07-2007 10:43:49
codes, competition law, to environmental codes. The Chinese authorities are committed
under their WTO agreements to improve judicial enforcement of contracts and other
business codes, including those governing intellectual property and counterfeiting.
However, there has been little fundamental change in the judicial mechanisms for
enforcement. Neither the independence of the courts nor their jurisdiction are adequately
established. Although the Chinese constitution states that judicial proceedings are to be
free of interference from other government and political entities, judges, courts, and other
judicial organs remain under their supervision and dependent on them for funding. The
legal obligations of other government entities to enforce or obey court decisions are not
adequately established, and court decisions are often ignored as a result. Enforcement is
further hampered by the limited experience of China`s courts with civil law proceedings,
and the limited training of judges and other judicial personnel. To improve enforcement
the key objective is to strengthen the independence, clarify the jurisdiction of courts, and
to invest in building up legal know-how.
13.5. Conclusion
China is living through a time of increased social unrest, viewed as potentially
destabilising for the regime. The Hu-Wen administration is perfectly aware of the
urgency of addressing China's problems, and acknowledges that, important as economic
efficiency is, it should not come at the expense of distributive justice. The administration
is aware that official corruption is one of the main causes of people`s resentment and is
publicly committed to fighting corruption.
Nevertheless, while the restructuring of the Chinese economy has been fairly rapid,
political reform has been lagging behind. Some progress has been made (e.g. the policy
of modernisation and professionalisation of the bureaucracy, the opening-up to
entrepreneurs in the Party, the organisation of elections at grassroots level, and the
development of a civil society in the country). Furthermore, in the face of rising social
unrest and rampant official corruption, the new Chinese leadership seems to stand for
more transparency, greater accountability and more distributive justice. Those positive
signs towards changes in policy direction should not be underestimated. However, so far
the political reform has been geared essentially towards adapting the existing political
system to a new socio-economic environment by perfecting and reinforcing one-party
rule - not by challenging it. Fundamentally, the CCP retains its grip on power, including
its control of the military.
Despite the slow pace of political reforms, it seems that a strong majority of the urban
and rural population supports the regime thanks to China`s successful economic
development, its self-affirmation as a strong nation (in particular the reunifications with
Hong Kong and Macao represent the achievement of national goals), and the regime's
ability to preserve political stability. Many are convinced that the regime has saved China
from a fate similar to that of the former Soviet Union. Moreover, a degree of pragmatic
nationalism helps the government to hold the country together. However, aggressive
nationalism that might get out of control would risk undermining the conditions
conducive to the country`s continued growth.
China`s society is increasingly diverse, and new interests have emerged. It appears that
the profound changes have been accompanied by an increasing accommodation between
the political system and the interests of this more diverse society. The state-society
relationship is based on a very strong convergence of interests that for the time being
seems to enable the government to give some relative freedom to a number of social
groups, while these groups know perfectly where their limits of action are.
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A new, better-educated and more open generation is emerging. But that does not
necessarily mean that the Party`s rule will be challenged. On the contrary, the CCP has
shown that one of its greatest strengths is its faculty to adapt to changing times.
Furthermore the new generation is no less nationalist than its predecessors. Such
accommodation may delay for some time any real political liberalisation. Instead, the
new generation is reflected in the Party leadership, where a new and heterogeneous
political generation composed both of party officials, private entrepreneurs, and a
foreign-educated elite is emerging. However, it remains difficult to say whether this will
be for the best - a more balanced, representative and pluralistic political system - or for
the worst - a harsh struggle for power.
If the political opening at the top is pursued and if it is combined with bottom-up
pressure, it may well lead to the emergence of a new Chinese political era conducive to
genuine political reform. However, this is far from certain.
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PART III: WHAT CHALLENGES IS EUROPE FACING?
China's rise provides significant opportunities for the EU. China offers an important
market for our exports and provides a wider variety of increasingly high-quality. low
cost imports for consumers and firms alike.
However. the emergence of China also presents the EU with a set of challenges. One set
is economic in nature. China's rise. like international trade in general. strengthens the
opportunity to specialise according to comparative advantage. Specialisation requires a
continuous reallocation of resources to sectors where the EU has a comparative
advantage. Well before the advent of China there were signs that this reallocation
process was not working as smoothly as it might in Europe. For example. workers who
are made redundant by trade shifts do not easily find a job elsewhere. While China does
not add anything qualitatively new in this respect. it nevertheless accentuates the
problem by dint of its size and largely unprecedented speed of development. This pace is
unlikely to diminish markedly in the years to come. On the contrary. there are signs that
China is gaining a comparative advantage in sectors that are increasingly important for
Europe. e.g. electronics. mechanical engineering and. potentially. car making.
Another set of challenges relates to the political side. China's foreign policy has so far
been more or less entirely devoted to ensuring favourable conditions for economic
development. Gradually. however. China is likely to use its increasing economic might
by exercising more political clout. It is already becoming increasingly assertive on the
international stage. This is an entirely natural and welcome development. as e.g.
illustrated by China's constructive role in the international talks on North Korea.
Nevertheless. it is natural that the emergence of a large country with its own history. set
of preferences and interests may lead to differences of views. For example. in its quest to
secure energy. China has not hesitated to engage with countries that the EU and the
international community at large have decided to shun. Moreover. Europe and China
continue to hold differing views on e.g. political participation. human rights and the rule
of law. There are also potential challenges that the EU needs to consider. arising from
China's actions and intentions vis-à-vis its partners in the East Asian region and the
region's main security provider - the United States.
Overall. Europe needs to adjust to the new reality of an increasingly wealthy and
assertive China. The EU's policy vis-à-vis China should therefore focus on a number of
objectives. First. the EU needs to improve its understanding of where China stands and
where it is going in order to place policy on a firm foundation. Second. in view of the
importance of a wealthy China and its orderly integration into the international system.
the EU should assist China in overcoming the challenges of transition and reform. Third.
to cope better with economic competition from China. the EU needs to improve its
competitiveness and ability to adapt. Fourth. to reap the full benefits of China's
economic opportunities. the EU needs to get China to strive for effective market access
reciprocally. Finally. the EU needs to continue to anchor China firmly in the
international system and continue to engage in an ongoing dialogue of where the system
should be heading and defend views that we hold dear.
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14. THE ECONOMIC IMPACT OF CHINA`S RISE
This chapter discusses the impact of China`s growth performance on economic relations
between China and Europe. Its focus on the EU complements chapter 3, which
discussed China`s impact on the world in general. Like other countries and regions, a
growing Chinese economy provides great trading potential and investment opportunities
for European business, and offers EU consumers a wider variety of better priced
products. It may also present specific challenges for the EU economy, as this part of the
report will demonstrate. Section 1 discusses EU-China trade patterns and
competitiveness trends. Section 2 discusses European FDI flows into China
228
while
section 3 discusses the role of European Multinational Firms in China`s international
division of labour.
14.1. EU trade and China
14.1.1. Overall Trade Position
The principal driver of recent European trade growth has been increased integration in an
enlarged Europe, between the EU-15 and EU-10. However, growth in extra-EU trade has
been most pronounced with China. In 2005, China become Europe`s second most
important external trade partner, behind the US.
EU-15 exports to China grew annually at 9% over the period 1995-2002.
Figure 14-1: Shifts in the Geographical Focus of EU-15 Exports (Manufacturing)
1992 1994 1996 1998 2000 2002
0
5
10
15
20
25
30
35
% Share of Extra EU15 exports
South East Asia
EU
Neighbours
1992 1994 1996 1998 2000 2002
0,4
2,4
4,4
6,4
8,4
10,4
12,4
% Share of Extra EU15 exports
Americas (excI
USA)
US
Japan
EU10
China
India
Source: European Commission (2005b).
However, China`s importance for the EU is primarily as a market to source imports.
Imports from China have grown faster than exports to China, rising by 17% per year over
the last five years.
228
For an analysis of the consequences of the increased attractiveness of China as a destination of foreign
investment for the European economy, see also Belessiotis, Levin and Veugelers (2005).
140
01_2006_4142_txt_EN.indd 140 12-07-2007 10:43:50
Figure 14-2: EU-15 trade with China
0
20
40
60
80
100
120
140
1999 2000 2001 2002 2003 2004
import
Export
Billion of Euro
Source: Eurostat
This unbalanced trade structure has led to the emergence of growing deficits in China-
EU trade, as the following graph documents. Trade deficits are not unique to China,
however. All three areas of Asia have opened up significant trade gaps with the EU. The
trade deficit with China of nearly 0.5% of GDP is at similar level to that with Japan.
These deficits at the bilateral level are to a large extent offset at the aggregate level by
the buoyancy of the US market, where the EU has seen a sharp turnaround in its trading
position.
Figure 14-3: Extra-EU-15 Trade Balances
0
0,2
0,4
0,6
-0,2
-0,4
-0,6
% of GDP
B92-97 B98-03
Americas
(ExcI US)
China
South East Asia
(ExcI China)
US
India
EU10
EU
Neighbours
Japan
Source: European Commission (2005b).
141
01_2006_4142_txt_EN.indd 141 12-07-2007 10:43:51
The surge of imports from China to the EU has to a considerable extent been boosted by
EU trade measures. China has since 1980 been included in the Community System of
Generalised Tariff Preferences (GSP) and has become one of its greatest beneficiaries.
The value of imports to EU Member States from China that were under the coverage of
the GSP in 1995 amounted to 53.6% of total EU imports from China. Since then the EU
has been phasing out GSP preferences towards China.
14.1.2. Trade Position by Member State
Germany is the largest Member State exporter to and importer from China. In 2003,
Germany accounted for Ú18.3bn or 44% of total EU exports to China, followed by
France (Ú4.7bn or 11%). In turn, Germany was also the largest importer from China
(Ú22.5bn or 21%), followed by the United Kingdom (Ú17.3bn or 16%), the Netherlands
(Ú14.7bn or 14%), France (Ú9.6bn or 9%) and Italy (Ú9.5bn or 9%).
14.1.3. Trade Position by Sector
More detailed data by product groups suggest that the EU-15 trade balance with China
worsened between 1996 and 2002 in nearly all of the broad product groups. The only
exception to this among the biggest industries is trade in chemicals, where the
improvement was caused primarily by the soaring Chinese demand for intermediary
goods.
Table 14-1: EU-15 Trade with China by Broad Product Groups
Exports Imports Trade balances
Growth
a)
Growth
a)
Chan
ges
2002
1996-
2002
2002
1996-
2002
2002 1996
1996-
2002
Product groups
Ú mio in % Ú mio in % Ú mio Ú mio Ú mio
Total manufactured
products
37016 8.9 47389 14.5 -10373 1,992
-
1236
6
Of wh/ch:
Food products, beverages
and tobacco
546 -2.8 1097 2.2 -551 -277 -274
Textiles and textile
products
696 10.0 6810 8.6 -6114 -3455
2658
Leather and leather
products
452 13.7 2537 9.0 -2085 -1201 -884
Wood and wood products 251 38.8 587 4.5 -336 -405 69
Pulp, paper and paper
products; publishing and
printing
1101 20.3 248 17.7 853 223 630
Coke, refined petroleum
59 25.6 338 3.4 -279 -256 -24
products and nuclear fuel
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01_2006_4142_txt_EN.indd 142 12-07-2007 10:43:51
Chemicals, chemical
products and man-made
fibres
4867 15.9 2955 5.5 1912 -297 2209
Rubber and plastic
products
513 23.0 1517 14.7 -1005 -460 -545
Other non-metallic
mineral products
358 6.1 755 9.8 -397 -155 -242
Basic metals and
fabricated metal products
2938 12.4 3019 8.4 -81 -426 345
Machinery and
equipment
11450 4.1 4379 21.7 7072 7542 -471
Office machinery and
computers
942 33.6 6556 31.3 -5614 -1313
4301
Electrical machinery and
apparatus n.e.c.
2961 13.0 2826 22.0 135 382 -246
Radio, television and
communication
equipment and apparatus
3088 4.8 5988 23.4 -2900 289
3190
Medical, precision and
optical instruments,
watches and clocks
2236 17.5 1293 14.6 943 34 909
Transport equipment 4308 8.8 1938 30.9 2369 2092 277
a) Average annual growth rate.
Source: EC-DG ENTR, Competitiveness report 2004
Source: European Commission (2005a).
In line with the general trend in Chinese exports, as reported in Part I, the data for the
EU-15 show a remarkable growth of Chinese exports to the EU-15 in high-technology
sectors. This is not exclusive to China. The new Member States and candidate countries`
exports of computers and telecommunication equipment into the EU-15 also show strong
growth. As regards labour-intensive exports, these are more important for the candidate
countries than for the new Member States and China. Overall, this suggests that China
should not be seen solely as a low-cost producer. It is increasingly moving into high-
technology sectors, further challenging Western economies.
143
01_2006_4142_txt_EN.indd 143 12-07-2007 10:43:51
Figure 14-4: Share of Manufacturing Exports to the EU-15 by Type of sector
NMS: New Member States; CC: Candidate Countries (Bulgaria, Romania, Turkey
Source: European Commission (2005a).
Box 14-1: China, the EU and IT
229
As already discussed in chapter 2, China is becoming the hub of electronics manufacturing in the
developing world and is a key link in the value chain of many electronic products, particularly in PCs,
peripherals and mobile handsets. This Box analyses the implications for EU firms of China's rise in IT.
China`s performance in electronics has been impressive and is likely to continue. Aiming to establish the
whole value added chain in China, it will try to become less dependent on imports of upstream components
for the assembly of electronics. Its (potential) comparative advantage is strong and growing in production
equipment and semiconductors. These sectors are currently dominated by US enterprises, which will be
affected badly. For European firms, with no strong comparative advantage in IT sectors, there are only a
few opportunities to export to China, and then only in areas where EU firms can command sustainable
technology leadership. This concerns, for instance, the installation and upgrading of infrastructure for
telecommunication operators. At the same time as China is taking its place in world markets, Europe will
face growing imports of preassembled components. Final assembly will take place within Europe, close to
final customer markets. This implies inward FDI from China.

229
Based on European Commission (2005a).
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01_2006_4142_txt_EN.indd 144 12-07-2007 10:43:52
Box 14-2: China, Textiles, the EU and the WTO
230
China has become the focus of considerable debate recently following the liberalisation of textile quotas
with the expiry of the Agreement on Textiles and Clothing on 1 January 2005. Over the period 1996-2002
China`s trade surplus with the EU-15 in textiles and textile products was Ú2.7bn and has since increased
further. China is competing in the EU textiles market with other foreign producers. Between 1995 and
2004 China`s market share in textiles and textile products in the EU-15 rose by some 4 percentage points
(to 43.3%) as did the share of Bangladesh (to 8.7%) followed by Turkey`s growth of 2.6 percentage points
(to 22.6%). These increases have been at the expense of Egypt, India and the Maghreb (Algeria, Morocco
and Tunisia): countries which together have experienced a decline in market share of some 10 percentage
points during this period. The share of textiles and textile products in China`s total exports to the EU-15
declined by close to 10 percentage points between 1995 and 2004. The data confirm the EU`s comparative
disadvantage in these products and the substantial gains from trade China`s emergence in the international
trading system offers.
14.1.4. EU-China competitiveness trends
To assess how European firms will be affected by China`s rise we have to compare the
profile of sectors in which both China and Europe are developing a comparative
advantage. This analysis, although the data are unfortunately not the most recent,
suggests that there is a degree of complementarity between developments in China`s
and the EU-15`s comparative advantages, as table 14.2 illustrates.
In most areas where China shows decreasing trade competitiveness, the EU-15 shows a
gain in revealed advantages, like chemicals and rubber and plastics, or constant
competitiveness, as in electrical engineering. In areas where China has gained in
competitiveness, the performance of the EU-15 is more mixed. In mechanical
engineering and electronic engineering the EU-15 has seen its competitiveness decline.
In computers, where China`s improvement has been most marked, EU-15`s
competitiveness has been only modestly affected, which nevertheless means remaining at
a low and disadvantaged position. The improvement in China`s competitiveness in cars is
still modest (with a negative RCA in 2001), while the competitiveness of the EU-15 did
not change much and remained positive in the observed period. But given that cars have
been targeted as a strategic sector by the Chinese government (cf. below), the trend in
China`s competitiveness in cars is most likely to be upward. Somewhat surprisingly, the
EU-15 has been gaining competitiveness in food and beverages and in textiles and
clothing. As regards the latter, the improved situation for European producers reflects the
strength of high-end products and luxury brands.

230
Based on European Commission (2005a).
145
01_2006_4142_txt_EN.indd 145 12-07-2007 10:43:52
Table 14-2: Revealed comparative advantage: China versus EU15
Sectors in which EU15
has a deteriorating RCA
position
Sectors in which
EU15 has more or
less maintained its
RCA position
Sectors in which EU15
has improved its RCA
position
No RCA RCA No RCA RCA No RCA RCA
No
RCA

Wood
(25)
Metals
(27/28)
Paper
(21/22)
Chemical
(24)
Rubber (25)
Sectors in
which China
has a
deteriorating
RCA position
RCA
Minerals
(26)
Electric
(31)
Optical
(33)

No
RCA
Mechanical
(29)
Cars
(34/35)

Sectors in
which China
has improved
its RCA
RCA
Leather
(19)
Electronic
(32)
Computer
(30)

Food&Bev
(15/16)
Textiles
(17/18)
Note: Increase/decrease of RCA considered over the period 1995-2001. Whether a RCA is held or not is
evaluated at 2001.
Source: European Commission (2005a).
The challenge posed by China is particularly relevant for the new Member States, as
Table 14-3 illustrates. Since the mid-1990s, the new Member States have improved their
trade performance in car manufacturing, a sector where China has as yet not developed a
comparative advantage, despite modest improvements. Sectors with declining EU-10
RCAs are textiles, clothing and leather products, and food & beverages, branches in
which the new Member States had performed strongly in earlier times but where they
currently face stiff competition on global markets. In all these sectors China is
improving its RCAs. Finally, in computers and electronics, where China has taken a
tremendous step forward and developed a comparative advantage in both sectors, the
new Member States have also improved their position. While they have developed a
comparative advantage in electronics, they have so far failed to develop a comparative
advantage in computers.
146
01_2006_4142_txt_EN.indd 146 12-07-2007 10:43:53
Table 14-3: Revealed comparative advantage: New Member States
Sectors in which EU10 has a
deteriorating RCA position
Sectors in which EU10 has
improved its RCA
No RCA RCA No RCA RCA
No
RCA
Chemicals (24)
Rubber (25)
Wood (20)
Metals (27/28)
Paper (21/22)
Sectors in which China has
a deteriorating RCA
position
RCA Electrical (31) Minerals (26) Optical (33)
No
RCA

Mechanical
(29)
Car (34/35)
Sectors in which China has
improved its RCA
RCA
Food&Bev
(15/16)
Textiles
(17/18)
Leather (19)
Computers
(15)
Electronic (32)
Note: Increase/decrease of RCA considered over the period 1995-2001; Whether an RCA is held or not is
evaluated at 2001.
Source: European Commission (2005a).
14.2. FDI from Europe into China
As already documented in Part I, Europe is not one of the most important investors in
China. European FDI engagement in China is very moderate in quantitative terms,
accounting for less than 10% of total FDI inflows into China. However, European
investment projects in China are on average more technology-intensive compared to FDI
from e.g. Hong Kong, Taiwan and South-East Asia.
Table 14-4: FDI inflows into China, 1995-2002
1995 1996 1997 1998 1999 2000 2001 2002
World 37.520.5 41.725.5 45.257.0 45.462.7 40.318.7 40.714.8 46.877.6 52.742.9
EU-15 2,131.31 2,737.06 4,171.15 3,978.73 4,506.51 4,479.46 4,182.70 3,709.82
In % 5.7% 6.6% 9.2% 8.8% 11.2% 11.0% 8.9% 7.0%
Source: National Bureau of Statistics, MOFCOM.
Only a very small share of total European FDI outflows finds its way to China.
231
In 2002
the vast majority of the EU-15`s outward FDI was directed to other EU-15 Member
States. Outside the EU-15, the major destination country remains the US. Despite the
substantial increase in FDI inflows to China since the early 1990s, the EU-15 FDI
outflows to the new Member States were much greater than those to China.
232
There
231
A detailed discussion of European FDI in China be found in van den Bulcke et al. (2003).
232
US firms appear to be investing more in fast-growing emerging countries than their EU counterparts.
Asian emerging economies were the destination of 12.3 per cent of US FDI between 1999-2002.
147
01_2006_4142_txt_EN.indd 147 12-07-2007 10:43:53
would appear, then, to be scope for Europe to develop its investment relationship with
China further.
Table 14-5: EU-25 FDI outflows 1995-2004
Euro million and %
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
China 787 1,654 1,816 435 2,254 2,428 2,292 3,102 2,999 2,969
(in %) 0.6 1.2 0.9 0.1 0.3 0.2 0.4 0.6 0.8 1.0
India 348 342 606 840 925 733 348 1,074 653 1,036
(in %) 0.3 0.2 0.3 0.2 0.1 0.1 0.1 0.2 0.2 0.4
WorId 124,099 143,393 206,573 368,197 738,674 1,126,186 632,543 494,482 393,104 295,739
Source: Eurostat.
The comparatively weak presence of the European economies in China can to a large
extent be explained by historical developments in Europe itself. The dynamic progress in
the process of European integration and of German re-unification and the sudden
accessibility of East European markets has absorbed substantial capital and management
capacity that otherwise might have been allocated to ventures in China. The relatively
moderate share of the West European economies, however, cannot hide the fact that the
absolute volumes of China-bound FDI flows have multiplied over time. For instance,
German FDI into China in 2002 was 39 times its 1985 level, for the UK this was a
multiplier of 12, and for France 17.
Table 14-6: European FDI Flows to China, 1997-2002, by country
1997 1998 1999 2000 2001 2002
Austria 74.61 21.13 23.17 22.59 57.78 67.27
Belgium 33.26 28.04 83.22 56.16 20.02 124.28
Denmark 16.81 62.66 84.91 49.46 56.38 71.09
France 474.65 714.89 884.29 853.16 532.46 575.60
Germany 992.63 736.73 1373.26 1041.49 1212.92 927.96
Italy 215.04 274.57 187.44 209.51 219.98 176.74
Netherlands 413.80 718.82 541.68 789.48 776.11 571.75
Spain 38.81 53.83 17.54 34.00 33.89 92.24
Sweden 42.81 133.42 155.80 159.24 84.39 99.80
United Kingdom 1857.56 1174.86 1044.49 1164.05 1051.66 895.76
EU-15 4171.15 3978.73 4506.51 4479.46 4182.70 3709.82
Source: NBS, MOFCOM.
The development of European investment in China follows the general trend of China`s
market transformation and opening to the world economy. The 1980s were characterised
by a wait-and-see attitude reflecting the institutional deficiencies in China`s FDI
regulations. Since 1992, the overall conditions for foreign investors in China have
appeared to be more favourable than ever before. In line with global FDI inflows into
China, cf above, European FDI flows towards China picked up markedly. China`s
membership of the WTO has, generally, provided further stimulus to extend European
FDI engagement in China. Depressed business cycles and a concentration on the EU
enlargement in May 2004, however, resulted in an overall reduction of European FDI
flows to China in 2002.
148
01_2006_4142_txt_EN.indd 148 12-07-2007 10:43:53
Figure 14-5: European FDI Flows to China, 2002
(In % of total)
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
G
r
e
e
c
e
P
o
r
t
u
g
a
l
I
r
e
la
n
d
L
u
x
e
m
b
o
u
r
g
F
in
la
n
d
A
u
s
t
r
ia
D
e
n
m
a
r
k
S
p
a
in
S
w
e
d
e
n
B
e
lg
iu
m
I
t
a
ly
N
e
t
h
e
r
la
n
d
s
F
r
a
n
c
e
U
n
it
e
d

K
in
g
d
o
m
G
e
r
m
a
n
y
Source: NBS, MOFCOM
In the past, European FDI to China has mostly been resource seeking¨, and accordingly
European investment projects in China are highly concentrated in manufacturing
activities. European capital has been attracted by the low cost of production in China and
less by the actual size and potential of the Chinese market. Consequently a considerable
share of foreign production has been exported, and not been sold on the Chinese market
(cf section 14.3).
14.3. Trade performance of foreign firms investing in China
233
A considerable share of the EU`s trade with China is conducted with foreign firms
located in China. In recent years about half of the EU-15`s export / import trade with
China has been conducted with foreign firms. From the foreign firm sector`s point of
view, however, the EU is not of equal importance, accounting for no more than about one
seventh of total trade of foreign firms. Imports by foreign firms from the EU were more
important in the early 1990s, while foreign firms` exports to the EU have become the
dominant feature only since the late 1990s. Today, exports by foreign firms located in
China to the EU surpass their imports from the EU by a wide margin, highlighting the
resource seeking character of many foreign firms as well as differing growth rates in their
absorption of European capital goods and machinery, on the one hand, and EU imports of
light industrial products from China, on the other.
These developments can to a large extent be explained by the trend in global and
European FDI in China. EU exports to China are mainly concentrated on capital goods,
233
Background report to European Commission (2004).
149
01_2006_4142_txt_EN.indd 149 12-07-2007 10:43:54
especially machinery imported by local enterprises in order to establish or upgrade
production facilities. While such exports have been directed to customers in China
irrespective of their ownership structures (state, collective, domestic private or foreign)
and have therefore been able to develop at an early stage in bilateral trade relations, most
EU imports from foreign enterprises located in China are founded in complex, long-term
business relationships. A considerable share of these imports is comprised of intra-firm
trade, whereby EU enterprises source inputs or final products from their Chinese
affiliates. Another part is constituted by (European or third-country) original equipment
manufacturers which have relocated their manufacturing plants from a third country (e.g.
South East Asia or Eastern Europe) to China in order to benefit from lower production
costs and continue to supply their European customers from this new production base.
Accordingly, the marked increase in FE exports to the EU goes hand in hand with the
establishment of large production capacities by resource seeking FEs as part of the first
boom¨-period for China-directed FDI starting in 1992, and is further intensified by
China`s rising importance as a global production base in the wake of WTO accession in
2001.
14.4. Conclusion
China`s WTO commitments have helped create shared opportunities for Chinese and
European business. In 2004 the European Union became China`s largest trading partner
and China the European Union`s second largest, behind the US. A considerable share of
the EU`s trade with China is conducted with foreign firms located in China. European
companies are investing in China, but to a lesser extent, leaving further opportunities to
be exploited.
Despite the win-win situation in the long run, in the short term there will be restructuring
costs to be considered in the EU, particularly in those areas where the EU is losing and
China is rapidly building sustainable comparative advantage in world markets, such as
electronic and mechanical engineering and potentially also in car making.
150
01_2006_4142_txt_EN.indd 150 12-07-2007 10:43:54
15. CURRENT EU-CHINA POLICIES
The political side of the EU-China relationship is often perceived by observers as being
limited to joint declarations on global multilateralism and promoting democracy, peace
and stability. Some analysts wonder whether China and the EU really share the same
values, the same interests and the same vision of multilateralism.
234
As a prelude to the
final chapter`s policy discussion, this chapter reviews the way in which the EU currently
engages with China.
15.1. Current EC objectives and institutional set-up
The EU has since 1998 had five long-term aims as regards China:
(i) engaging China further via an enhanced political dialogue,
(ii) supporting China`s transition to an open society based on the rule of law and
respect for human rights,
(iii) integrating China further into the world economy (WTO, reform, sustainable
development, etc),
(iv) making better use of existing European resources, and
(v) raising the EU`s profile in China.
235
These aims were complemented in 2001 by short- and medium-term action points¨.
236
On the basis of a 2002 strategy paper, the aims and actions were reaffirmed in a 2003
Communication, timed to coincide with the arrival in power of a new generation of
Chinese leaders.
237
The Communication provided an updated list of detailed and concrete
action points aimed at delivering the aims outlined above. These action points have since
guided the Commission`s action. Evaluations are made regularly to verify whether
progress has been made.
238
On the basis of these aims and actions, the European Commission has established an
institutional set-up for ongoing dialogue with the Chinese authorities. This is summarised
in the graphs below. They illustrate the breadth and depth of contacts, which range from
234
François Godement, Emergence d'une Superpuissance. La Chine . Partenaire ou Adversaire ' Actes
de la journée d`études du 14 septembre 2004 organisée par la Fondation pour la Recherche Stratégique
- Alex Berkofsky. EU-China Relations . Strategic Partnership or Partners of Convenience ' German
Foreign Policy In Dialogue, Vol. 6, Issue 6, June 2005 - Bruno Tertrais, Tectonique des Plaques en
Asie, Notes de la Fondation pour la Recherche Stratégique, 28 septembre 2005
235
European Commission (1998), Building a Comprehensive Partnership with China¨, COM (1998)
181.
236
European Commission (2001), EU Strategy towards China: Implementation of the 1998
Communication and Future Steps for a more Effective EU Policy¨, COM (2001) 265.
237
European Commission (2003), A Maturing Partnership - shared interests and challenges in EU-China
relations¨, COM (2003) 533.
238
DG RELEX (2005), China Action Points/Guidelines for Action - Stocktaking April 2005¨.
151
01_2006_4142_txt_EN.indd 151 12-07-2007 10:43:54
an annual Summit at the most senior policy level covering all areas, to ongoing detailed
discussions at service level in specific policy areas.
Figure 15-1: Current architecture of EU-China relations

(a) PoIiticaI diaIogue

Summit
(annual)

Troika Ministerials
(1-2/year)





Meetings between GAERC President and
Chinese Ambassador in Presidency capital
(1x/presidency)

Meetings between Chinese Foreign Minister
and EU Heads of Mission in Beijing
(1x/presidency)





EU-China Strategic Dialogue
(Deputy Foreign Minister level,
1-2x/year)




Political Directors (1x/year)




Regional Directors (1x/year)










High-level
consul-
tation on
illegal
migration
and
trafficking
(1x/year)

Human rights
dialogue (1x/
presidency)

Asian affairs

Non-
proliferation

Conven-
tional
arms
exports



(b) Economic reIations

EC-China Joint Committee
(1985 TCA, 1x/year)

Ministerial

Senior Officials Meeting (SOM)







Economic and Trade Working Group










EC-China development cooperation programme
(Ú200m, 2003-2007)



152
01_2006_4142_txt_EN.indd 152 12-07-2007 10:43:56

(c) SectoraI agreements and diaIogues


Science
and
Techno-
logy
Agreement

Satellite
navigation
coopera-
tion
agreement
(Galileo)

Customs
coopera-
tion
agree-
ment

Maritime
transport
agree-
ment

Nuclear
research
coopera-
tion
agree-
ment
(Euratom)

Tourism
agreement
(ADS)




Trade
policy
dialogue

Dialogue
on
intellectual
property
rights and
geo-
graphical
indications

Dialogue
on
product
safety and
sanitary
and
phyto-
sanitary
standards
Dialogue
on textile
trade

Dialogue
on macro-
economic
issues
and
financial
market
regulation

Dialogue
on compe-
tition
policy

Dialogue
/ working
groups
on
industrial
policy
and
regulatio
n


Dialogue
on
employme
nt and
social
policy
Environme
nt Dialogue
/ Working
Group

Energy
Working
Group /
Conferenc
e

Dialogue
on
agricultur
e

Informatio
n Society
Dialogue /
Working
Group

Cooperatio
n on space
science
and
technology

Regular
exchange
s on
education
and
culture


Possible
future
dialogue
on
regional
policy
Possible
future civil
aviation
agreement

Possible
dialogue
on
transport
policy (in
general)

Source: DG RELEX (2005), Situation as at 1 December 2005
These dialogues are underpinned by the cooperation efforts of the European Commission
in China. For instance, the EU China Trade Programme supports capacity building in
China on trade policy issues.
Moreover, the European Commission maintains a delegation employing some 100 people
(local staff included). Its only office is in Beijing. A large part of the staff are employed
on development cooperation and related activities (finance and contracts). A smaller part
are active in economic policy (trade, information society and telecommunications and
S&T).
Since 2000, The European Union Chamber of Commerce in China has been the official
voice of European Business in China, recognised as such by the European Commission
and the Chinese authorities. The core structure of the Chamber is based on Working
Groups, which meet regularly in Beijing, Shanghai and Nanjing and discuss business
issues in their respective sectors. Each year the ECCC publishes a Position Paper, which
details the key concerns and recommendations of each group with regard to WTO
implementation issues, trade issues beyond these WTO commitments, regulatory issues
and broader policy-related issues.
15.2. EU ~ China trade policy
The EU`s policy vis-à-vis China on trade issues can mobilise a range of resources at a
multilateral and bilateral level. First, since China`s accession to the WTO in 1992, the
monitoring of the full and effective implementation by China of its WTO commitments
takes place in a multilateral setting. Given that the EU shares similar concerns with
other global players, most notably the US, on ensuring China`s path towards effective
liberalisation, a multilateral approach towards these issues is most natural. While China
153
01_2006_4142_txt_EN.indd 153 12-07-2007 10:43:58
has made substantial progress in implementing its WTO commitments, notably in the
tariffs area, there remain substantial non-tariff barrier areas, such as protection of
intellectual property rights, open government procurement, investment restrictions,
industrial policy etc where more needs to be done to ensure effective market access. In
any dispute, the WTO Dispute Settlement Instrument can be used to ensure
implementation.
239
There is also the Trade Barrier Regulation, which allows economic
operators to ask the Commission for an investigation. Where there is found to have been
a WTO violation, it has to be followed by a WTO case as a DSC. But before, peer
pressure (for instance within the context of the yearly Trade Policy Review Mechanism
of China) is a useful means of engaging China in a more positive way.
Beyond current WTO commitments, both the EU and China have a strong stake in taking
trade liberalisation further, for example in the area of services. More particularly, the
importance of bringing the current Doha Development Round to a successful conclusion
cannot be overstated. However, for the moment, China`s appetite for taking an active
role in these negotiations has not been commensurate with its new role in world trade.
Instead, it seems to prefer a policy of bilateral and regional trade agreements rather than
putting effort into supporting multilateral negotiations.
At the bilateral level, the EU and China have a multitude of Sectoral Dialogues, as
discussed above. Together with the meetings of the Joint Committee, the Economic and
Trade Working Group and the annual summits, these provide ample opportunity for
contacts. These contacts have grown out of the 1985 Agreement.
Overall there is a feeling that on many trade and market access issues, like IPR, progress
is only limited, questioning the effectiveness of the EU`s trade policy instruments.
Should the EU be more aggressive? Does it employ enough resources? Is it analysing
China correctly? To increase the effectiveness of its trade policy instruments, the EU
should also look beyond trade policy to leverage other policy areas (cf below).
15.3. EU and China: two visions of foreign policy
The EU`s commitment to its founding principles of human rights, democracy and the rule
of law, and its attachment to promoting good governance and effective multilateralism,
are the main pillars of its policy vis-à-vis China, as illustrated by the overall political and
sector dialogues outlined above. On China`s side, the Five Principles of Peaceful
Coexistence, which include non-interference in other countries` internal affairs, are the
basis of its foreign policy in general and also vis-à-vis the EU. These two perspectives
may collide.
China`s first ever policy paper on China-EU relationship in 2003 refers clearly to the
Five Principles and emphasises that there is no fundamental conflict of interests
between China and the EU and neither side poses a threat to the other. However given
their differences in historical background, cultural heritage, political system, and

239
The EU has already once launched a DSC against China for auto parts. The TBR has so far not been
used against China.
154
01_2006_4142_txt_EN.indd 154 12-07-2007 10:43:58
economic development level, it is natural that the two sides have different views or even
disagree on some issues.¨
240
If disagreements are managed in a way that respects the interests of the two parties, it
will show that the EU-China relationship is mature enough to accommodate
disagreements while agreeing on fundamentals. However historical, cultural and political
differences may lead not only to different views but also to misunderstandings and
misinterpretations.
15.3.1. Human rights
In the lead-up to the 2005 EU-China Summit, Amnesty International`s EU Office
welcomed the fact that the EU has made the lifting of its arms embargo contingent on
human rights reform¨, but stressed that concerns remain in all areas under scrutiny. The
Chinese government has yet to present a coherent plan of reform and steps to improve its
human rights practices must be implemented in a clear and consistent manner.¨ Amnesty
International called on the EU to keep pressing the Chinese authorities for such steps in
the debate around lifting the arms embargo on China.¨ Actually the EU is actively
engaged in fostering a frank and constructive exchange on human rights issues with
China and stimulating the positive trends. The EU has notably launched a number of
projects to support NGOs which are active in the areas of promoting and protecting
human rights in China. The EU has constantly stressed that more should be achieved in
the field of civil and political rights, in particular with regard to freedom of expression,
religion and association and protecting the rights of minorities. Moreover the EU does
attach great importance to the release of the people imprisoned at the time of Tiananmen
- or who later commemorated the 1989 events.
However, a number of observers consider that so far no significant progress has been
made on the EU-China human rights dialogue initiated in 1996. In particular and despite
EU`s repeated requests, China has not yet given any timetable for ratifying the
International Covenant on Civil and Political Rights (ICCPR) and insists it will take
place on China`s terms. Whether the EU-China dialogue on the rule of law will achieve
further results remains to be seen. The EU insists that the rule of law is not synonymous
with rule by law while on the whole Chinese official documents refer more to the latter
than to the former.
15.3.2. Good governance
The EU genuinely believes that it can help China to achieve a better governance
capacity. In line with its founding principles the EU is seeking to assist China in this
transition period so that the country can move toward a more open society, and a more
representative and accountable government. However, some Chinese scholars see hidden
motives and double standards behind Europe`s stance.
241
Moreover, some Chinese
scholars believe that conflicts in ideology and values still remain in the China-EU
240
China`s EU Policy Paper, October 2003.
241
For example, David Shambaugh, a well-known US expert on China, notes that China`s Europe
specialists have begun to criticise the motives underlying the EU programme to promote civil society
in China as an ideological ruse to westernise and divide¨ China. David Shambaugh, The New
Strategic Triangle . U.S. and Europe Reactions to China's Rise, The Washington Quarterly, Vol.28,
Issue 3, Summer 2005, pp.7-25
155
01_2006_4142_txt_EN.indd 155 12-07-2007 10:43:59
relationship.
242
Huo Zhengde of the China Institute of International Studies, for example,
considers the EU`s support for China`s reform, opening-up and transformation into a
society based on respect for democracy and the rule of law as an attempt to prompt China
to accept Western ideology and to become more integrated with the international
community. He also stresses what he regards as the EU`s ambiguous international role,
i.e. the EU being in favour of multilateralism while at the same time being inclined to
intervene in other countries` internal affairs, as illustrated by the 1999 bombing of
Yugoslavia and the recent interference in Ukraine`s internal affairs.
15.3.3. Multilateralism
Though the EU is committed to multilateralism there is an impression of selective
bilateralism¨. Some fear that Europe is running a risk of finding itself marginalised in the
regional development of Asia - Asem and other dialogues notwithstanding. China is by
far the most important actor in the region for European interests and it has already been
argued that the sino-centricism of the Europeans might result in other Asian nations
being neglected. Moreover, there is no clear-cut regional leadership accepted by all
countries in the region.
15.3.4. International order
China`s quest for resources, its strict compliance with the principle of non-interference in
other countries` internal affairs, and the political ramifications of its relations with
countries such as Iran or Sudan pose the risk of a substantial undermining of the EU`s
capacity to influence other (developing) countries in the direction of good governance,
human rights and political freedom (see Chapter 4).
15.4. The EU, its Member States and China: a complex picture
Several analysts view the EU`s China policy as a clear example that the policies made in
Brussels are not necessarily the policies of all Member States.
On China`s side the challenge is to deal with the EU as a whole as against dealing with
the Member States individually. China has already complained that the EU has gained an
unfair advantage by hiding behind differing EU Member States` policies on issues such
as the lifting of the arms embargo. Even if the development of a Common Foreign
Security Policy (CFSP) over the coming years were to lead to an increasingly significant
EU role in shaping and managing the world order, the EU is not yet a comprehensive
foreign security player. The Chinese are fully aware that foreign policy remains in the
hands of Member States and that power - as defined by military means, sovereignty, and
even the possibility of influencing outcomes at the UN - remains vested at the national
level and that this will remain the case for the foreseeable future. China`s bilateral
relationship with Member States still serves as the basis of its multilateral relationship
with the EU.
243
Moreover many analysts consider that the EU is currently a regional
force and not a global force and that it will more likely develop into a decisive force for
the world rather than into a power per se.
242
Huo Zhengde, On China-EU Strategic Relationship, China Institute of International Studies, April
2005 - http://www.ciis.org.cn/item/2005-04-07/50919.html who
243
Huo Zhengde, ibid.
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On Brussels` side the challenge is to discuss issues such as promoting democracy, human
rights, and the rule of law with a degree of insistence that does not spoil either the EU
Member States` bilateral relations with China or the EU`s trade relations with China.
Some European experts wonder whether Member States see a role for EU policy towards
China going beyond trade or whether they prefer to pursue their own China policies on a
bilateral basis. China is sensitive to Europe`s desire to stand tall on the international
stage, convinced as it is that the emergence of a multipolar world is inevitable. In other
words if the EU can become a pole it is because of China`s status in the evolving balance
of world power.
244
In this regard some analysts consider that China is using the strategic
partnership for its own purpose, urging Brussels to lift its arms embargo and
transforming such a decision into an EU affirmation of independence from the United
States that will ultimately show the EU`s political maturity. This is illustrated by
statements from some Chinese officials, arguing that the EU should have the courage¨
and the statesmanship¨ required to act, i.e. to lift its embargo whatever the US position
may be.
245
15.5. The EU, the US and China: the risks of a triangular relation
Will the EU-US relationship be increasingly shaped by their views on how to adjust to
China`s rise? How is the EU going to play its geopolitical card between a firmly
established pole, the United States, and an increasingly sino-centric pole? Can Europe
continue to push its European/national interests in China if it risks alienating the United
States? Since Asia`s rise could eventually contribute to a multipolar world, whereby the
United States retains its supremacy but has lost much of its legitimacy, and as China is
inclined to see the American democratisation policy in the rest of the world as a part of a
hegemonic strategy, these questions are legitimate. Moreover, China`s continued
development will not solely be of its own making - it will also depend on the West`s
response.
15.5.1. The EU and the US - two different perspectives on China
The EU and the United States have differing interests. That is primarily because the EU,
unlike the US, has no significant security strategic interests in the region nor is it
expected to act as a regional security guarantor. As one analyst has put it: Europe has
the luxury to develop its relationship with China unencumbered by the strategic and
security responsibilities that the United States shoulders in Asia or the domestic role that
the Taiwan lobby plays in Washington.¨
246
244
Feng Zhongping of the China Institute of Contemporary International Relations (CICIR) thinks that
the EU-China relationship will help the EU in its long cherished endeavour to assert itself on the
world stage and become an independent pole¨ in world affairs¨. See Feng Zhongping, Analysis of
the China Policy of The European Union, Contemporary International Relations, Vol.8, Issue 4, April
1998 - Michael Pillsburg, China Debates the Future Security Environment, National Defence
University Press, January 2000
245
Huo Zhengde sees the EU`s eventual decision on the lifting of the embargo as a test of the quality of
the China-EU partnership, EU`s independence of the US, its stance on the potential crisis on the
Taiwan Straits and on the US strategic position and role in the Asian-Pacific region.¨ However, he also
points out that China and the EU are not a security threat to each other. Moreover, they do not need
each other or depend on each other as regards strategic security in the Asian pacific region. That is in
sharp contrast with the situation in which China and the United States are potential strategic rivals
while needing each other strategically.¨ Huo concludes that at this stage the China-US and the EU-
US relations are more important than the China-EU relations.¨
246
David Shambaugh, ibid.
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Economic issues dominate the EU's thinking on China, while the security perspective on
China is of relatively little importance. As one scholar has said, European countries do
not appear to have any clearly identified strategic interests in or politico-military
assessment of the regional security environment in East Asia, they have not made a
systematic assessment of the strategic implications of changes in Chinese military
power.¨
247
From a strategic standpoint it could be argued that given a European approach
to China which is predominantly economic, and the determination of China to acquire
know-how and technology, the EU`s main concern is to know whether European
exporters will be able in the longer term to continue expanding the market share for their
products in China while ensuring control over their core technologies. However, how
would the EU react to a possible crisis in the Taiwan Strait (should the EU remain neutral
or should it throw its full weight behind the U.S.?) is an issue which should be seriously
considered as well.
The situation is more complex for the United States, which is an influential presence and
a security guarantor, as illustrated by its bilateral alliances in the region and the political
links it has forged since 1945. This explains the American tendency to focus primarily on
China`s external posture and its military modernisation. The US concerns are fourfold:
Taiwan, the future of the Asia Pacific region, energy and trade. All four have a potential
for conflict.
The asymmetry between American and European interests in the region is a fertile
ground for misunderstandings, and many observers believe that there are strategic limits
that Europe should not cross. The discussion between the two sides over the European
arms embargo and its potential lifting was a case in point.
248
15.5.2. The EU's and the United States' shared interests towards China
The EU-US-China triangle is potentially unsettling if two sides manoeuvre against the
third. However, the limits to the triangular game can be clearly drawn once it is
acknowledged that Europe and the United States have much more in common in terms of
common values and global interests.
Europe and the United States agree that the most important issue is to manage China`s
smooth and peaceful integration into the established global system. Both have an interest
in China being a status quo power rather than a revisionist power. Both want to engage
247
An Anthony, Military Relevant EU-China Trade and Technology Transfers. Issues and Problems,
Conference on "Chinese Military Modernization: East Asian Political, Economic and Defence
Industries responses" , organised by CSIS, 19-20 May, 2005
248
François Godement, director of the Paris-based IFRI Asia Centre, thinks that this issue showed the
limits of the strategic partnership¨ between the EU and China. He describes this partnership as having
been conceived on the basis of Chinese commercial ambitions and the existing tools for European
action in Asia, i.e. European soft diplomacy`s tools. Such a partnership can work only in calm times
but cannot run the risk of provoking a crisis in China-United States relations. See François Godement,
La Relation Chine-Europe et Ses Implications Stratégiques, IFRI, 31 mars 2005.
Bruno Tertrais of the Fondation pour la Recherche Stratégique (FRS - Paris) notes that the
modernisation of the People`s Liberation Army (PLA) is to be able to resist the United States power,
to be in a position to blackmail Taiwan and to bolster the PLA`s ability to maintain internal order¨,
and he asks; are Europeans keen to signal China that they are ready to contribute to helping Beijing
satisfy these goals?¨ He concludes that we do not need another transatlantic crisis. Such a crisis
would play in the hands of those who may have a political interest in transatlantic division, including
in China.¨ See Bruno Tertrais, Europe and the Emergence of China. Consequences for the
Transatlantic Relationship. A European Perspective¨, Fondation pour la Recherche Stratégique.
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with China in the widest possible range of international institutions. They also share the
hopes of seeing China rise to become a responsible major power, a reliable economic
partner and an increasingly pluralistic and democratic state.
This broad commonality of values and interests should be taken further. Europe and the
United States should at least consult with each other and attempt to work out common
positions over China and more broadly over Asia wherever possible. Indeed to the
extent that the Chinese believe that Europe is sympathetic toward the need to balance and
constrain US power, they may be more likely to indulge in such thinking themselves. If
instead they see the United States and Europe coordinating their policies on matters of
common interests, from the Middle East to global issues to China itself, the Chinese may
be more likely to see the advantages of cooperation not merely for now but for the long
haul.¨
249
249
David C. Gompert, François Godement, Evan S. Medeiros, James C. Mulvenon, China on the Move. A
Franco-American Analysis of Emerging Chinese Strategic Policies and Their Consequences for
Transatlantic Relations, Rand 2005
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16. EU POLICY OBJECTIVES
The European economy is inextricably linked to the world economy, and it is essential
for European firms to be able to access international markets, exploit efficiency
advantages and access strategic assets in order to stay competitive. Being a part of the
world economy enables Member States to specialise according to their evolving
comparative advantages but also exposes the EU economy to constant economic shocks
and a continuous process of structural change. To be a successful partner in the world
economy therefore requires an ability to adapt.
Integrating China into the world economy is just another facet of this overall challenge
posed by globalisation, albeit in view of China`s size and rapid rise, a sizeable one. Just
as with the world economy, the EU benefits tremendously from trading with China.
The fundamental policy goals are therefore to (i) promote China`s orderly integration
into the world economy and become a stakeholder in the structures governing it and (ii)
to enable the EU to maximise the benefits and minimise the costs that derive from
globalisation and China`s economic rise. To achieve these fundamental goals, the EU
should pursue six objectives. First, the EU should base policymaking on a sound
understanding of China. Second, based on this knowledge of China and the challenges it
is facing, EU policy should aim to help China succeed. Third, in engaging with China,
EU policy should also aim to maximise the opportunities for EU firms and minimise the
risks they are facing. Fourth, to sustain the support for economic openness, EU policy
should also help to boost Europe`s capacity to adapt to the challenges China presents.
Fifth, EU policy should promote an open world economy, keeping our markets open
while achieving effective market access to the opportunities offered by China. Finally,
EU policy should play a constructive role in promoting what can appropriately be called
harmonious international relations¨ by being a constructive and reasoned voice in the
East Asian region. These objectives, and the action needed to achieve them, are further
outlined below.
16.1. Base policymaking on a sound understanding of China
EU policymaking needs to be based on a sound understanding of where China currently
stands and where the country and the region are going. Building this understanding
means improving analytical capacity, including economic analysis. The goal should be
to acquire a better understanding of where China stands on its development path, what its
genuine policy objectives are, the direction in which its comparative advantage is
evolving, what challenges it is facing and its long-term develpment. It also includes
political analysis, where the EU needs to improve its understanding of the different
forces at work within the ruling party and the different currents of political thought in
China. Achieving this will require the following action:
Refacas /aca/ presence and knaw/edge. The EU Delegation in China is currently
focused primarily on development cooperation, with relatively less weight devoted to
monitoring the EU`s economic and political interests (trade, investment, telecom,
science and technology, etc). This is in line with the EU`s traditional focus on
facilitating transition and reform. That work is important and will benefit the EU in
the long term. However, more resources are needed to monitor direct interests in the
economic and political field.
S(reng(hen ana/v(/ca/ capac/(v a( Camm/ss/an headqaar(ers /n Brasse/s. The
Commission should review current administrative resources devoted to China.
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Taking into account budget constraints, the scale of China-devoted resources should
nevertheless be more proportional to the economic and strategic importance of the
partner.
Ba//d ap ana/v(/ca/ resaarces arer (he med/am (erm. Several studies show that
knowledge of China is relatively weak and dispersed in the EU across the board, be it
in economic or political issues, at the level of governments (the Commission and
Member States), universities and think tanks. This is particularly the case when when
we look at the level of China expertise in the United States.
To build up a larger pool of expertise may need devoted funding. There is also a need
to improve interaction between (i) the Commission and outside experts and (ii)
Commission and Member States and (iii) the EU and China. The ECAN, EU-China
Academic Network, initiative is an interesting first step in this respect. It is an EU
supported network of academic institutions encouraging collaboration among
researchers on contemporary China.
Dere/ap a caheren( pa//cv s(ance. The EU`s China policy is determined by a
multitude of players (within the Commission, between Commission, Council and
Member States, etc). Developing a coherent policy stance calls for coordination.
It requires coordination within the Commission. Currently coordination is informal
and is judged to be working rather well. Nevertheless, the Commission should assess
the strengths and weaknesses of this informal coordination of the EU`s overall
position and everyday China-related actions undertaken by various departments.
Arguably, China has become so important and most issues have come to require a
systemic approach, that a coordinated policy response is systematically sought. While
informal coordination is effective, and desirable, its ad hoc nature appears
insufficient in view of China`s omnipresence and importance. Overall, the
Commission could consider setting up a main interdisciplinary hub that centralises
information.
It also requires coordination between the Commission and Member States.
Particularly on trade and FDI issues, Member States too often see themselves in
competition for China`s attention rather than in cooperation. For instance, in Trade
Policy the Commission speaks on behalf of the Member States. The complementary
area of Trade Promotion falls within the Member States' sphere of competence.
Closer coordination between the two areas would increase overall efficiency.
Naturally, the EU`s problems in this respect are generic.
250
To build up a common
strategic outlook and vision between Member States with respect to external policy is
a long-term endeavour. It is a worthwhile one though, particularly with respect to
China. Divergences clearly sow confusion and decrease the EU`s influence in China
and the East Asian region at large
Imprare effec(/reness af pa//cv. The EU should also boost its effectiveness by
coordinating with global trading partners and prioritising. The EU should coordinate
China-related actions with global trading partners that share similar interests and
views, as this may provide leverage. The recent joint WTO challenge with the US is a
useful example and we should see to what extent such joint actions are feasible on a
broader scale.
250
Better co-operation between EU institutions and Member States is an issue addressed by the
Communication from the Commission to the European Council of June 2006: Europe in the World -
Some Practical Proposals of Greater Coherence, Effectiveness and Visibility¨; COM(2006) 278 Final
- 8 June 2006.
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The depth and breadth of current EU-China cooperation and dialogue is impressive.
However, the recent proliferation of dialogues makes it difficult for the Commission
to effectively manage and deliver meaningful results in all areas. It is therefore better
to increase but also focus scarce resources on the most strategic areas.
16.2. Help China succeed
A harmoniously developing China is of major benefit to Europe, when it is fully
integrated and open to the world. It is therefore in our interest to assist China to address
the challenges it is facing, and where possible help the Chinese in their transition and
reform process. The EU has traditionally focused on helping to manage the internal
transition and reform process, to improve governance, strengthen civil society and the
rule of law. This support has worked well.
Moreover, the Community and the individual Member States have a wealth of policy
experience when it comes to political and economic reform, e.g. as regards the build-up
of competition policy, social welfare systems, administrative capabilities and the like.
Moreover, the most recent enlargement brought in Member States that have only recently
gone through a profound process of economic and political transition.
One important instrument at the EU`s disposal is development assistance. This
instrument should be put to better strategic use. Nevertheless, as development assistance
resources are scarce and as China becomes richer and increasingly able to take care of its
internal problems on its own, international donors, the EU included, need to reconsider
the size of the private and public aid financial flows to China. The difficulty in the case
of China`s rapid growth is to balance her legitimate needs as an emerging economy and
her status as an exporting power that is becoming increasingly effective as an
international competitor.
China`s build-up of its Science and Technology can be achieved in close international
cooperation, within current Chinese and EU S&T Programmes. The EU has opened its
Research Framework Programme (FP6) to China`s participation. It has also opened the
Galileo flagship programme to China. Within ERA-NET, there is the CO-REACH
initiative, recently launched to stimulate research cooperation with China by coordinating
bilateral programmes. Current Community and Member State programmes in the field of
education, such as the Erasmus Mundus Programme, could be geared even more strongly
towards international cooperation and exchange between China and the EU. More
attention should be given to actively promoting existing programmes to stimulate
participation by the best EU and Chinese scholars and to make sure these programmes
are leveraged into long-term benefits for all sides.
16.3. Maximise economic opportunities and minimise risks for EU firms
As evidenced above, international business is welcome in China and is regarded as
important in China`s development as, especially from EU firms, it contributes technology
and know-how. The Chinese market is a tremendous opportunity for EU firms where
they can exploit efficiency advantages, access strategic assets and develop a customer
base.
With each side being able to exploit its relative strengths, there is the potential for this to
be a win-win situation. Nevertheless, many uncertainties remain. China is a market and a
society characterised by rapid flux, where the institutional framework underpinning the
economy has not fully kept track and where national sentiments are increasingly present.
Therefore, foreign companies may find it difficult to access Chinese markets, particularly
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in 'strategic` sectors. And their (intellectual) property rights are not always fully
protected. While to a large extent this is a legacy of an old institutional framework, there
are increasing signs of intentional elements of industrial policy favouring national
champions, and lack of compliance with copyrights, intellectual property and the like.
EU firms establishing a presence in China need to recognise this uncertain reality with
extensive opportunities mixed with risks. EU firms should therefore carefully evaluate
the risks associated with their presence. Foreign investors need to be flexible, have a
long-term vision and build on their innovative capabilities to meet the hyper-competitive
Chinese market. Crucially, EU firms need to manage their intellectual property rights
assets strategically to sustain their advantage in the long run.
EU policy makers cannot afford to be naïve. They should fully recognise and understand
the reality of Chinese policy and continue to make the case for open markets. In
addition, they should support the business community by:
Supporting language and business training for Europeans doing business in China,
and vice versa. The Commission supported the establishment of the China Europe
Business School (CEIBS) in Shanghai, which provides high quality business
training to young Chinese and international students. It should also support specific
training in European business schools on doing business in China.
Backing the development of information and support services to help EU firms,
especially SMEs, into China.
Stimulating and coordinating export promotion and the organisation of trade
missions. Although export promotion is the prerogative of Member States, and the
EU should not try to substitute for them, some coordination could help to increase
visibility and efficiency, particularly for smaller Member States.
16.4. Improve Europe`s capacity to adapt
It is important to put the economic challenge associated with China`s rise in context. The
challenges associated with trade are only part of the everyday dynamism of a market
economy. Of this limited trade-related aspect, China is so far only a small part with
accordingly little in the way of employment effects.
However, there are reasons for concern. First, the pace of China`s transformation and
rapid build-up of comparative advantage in a broad number of areas, including higher
technology, is unprecedented. Second, comparative advantages of several Member States
are increasingly overlapping with China`s. Third, the European economy is inadequately
equipped to adapt smoothly and reallocate resources in response to shocks.
To address these concerns, the crucial challenge is to improve the European economy so
that globalisation and competition from China are no longer a threat to jobs, but an
opportunity for growth. To achieve this, the European economy needs to improve its
adaptive capacity. Policy should therefore have two goals: (i) improving competitiveness
and (ii) facilitating transition. Much of this is embodied in the now revised, but ever-
important Lisbon Strategy.
16.4.1. Improve competitiveness
There are a number of things that EU policy could do to improve the EU`s
competitiveness.
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Companies ultimately locate where the market is. EU policy should therefore strive
to provide a dynamic European market and should nurture a vigorous entrepreneurial
culture. This can be done by providing access to a large, integrated and growing
market. There are well-known challenges related to the EU`s quest to achieve a full
internal single market, and Commission action as regards improving regulatory
quality, achieving further liberalisation (notably in services), and minimising barriers
to entry and control of incumbents remains as important as ever.
EU policy should also strive to support an environment conducive to firms moving
into high value-added production. This can be done by e.g. stimulating and
improving research spending and taking actions to increase the likelihood of
innovations being translated into new value added (e.g. stimulating the emergence of
risk capital markets). EU policy could also create a better environment for businesses.
Another important goal for EU policy should be to invest in human capital, thereby
improving the skills of the workforce.
EU policy should also aim to improve the European economy`s structural ability to
adapt and adjust to shocks. This can be achieved by promoting further structural
reforms - aimed in general at reducing regulatory burdens, increasing labour market
participation and upgrading the stock of human capital. A crucial part is likely to be
labour market reform aimed at providing effective employment protection, improved
participation and enhanced safety and health conditions.
16.4.2. Facilitate transition
There is a role for policy to temporarily cushion the impact on incomes of workers
affected by structural change, while facilitating re-employment. While Member States`
social insurance systems have been devised in part to meet such needs, EU policy can
contribute, e.g. by using the recently agreed European Globalisation Adjustment Fund
(EGAF), which will provide support for the rapid redeployment of workers displaced by
sudden and major trade shocks. The EU can also initiate a debate on how to review the
policies and incentives for individuals to take up new work by reassessing tax and benefit
systems, and providing customised and speedy job search and placement assistance.
In order to cushion the regional impact of China-related economic shocks, EU policy
could consider short-term assistance to regions suffering severe trade-related shock,
provided that such assistance does not run counter to the overall goal of ensuring a
reallocation of resources economy-wide.
16.5. Maintain and promote an open world economy
China is in the process of assuming its natural place in the world economy.. But
economic leadership brings responsibility. The EU should try to enmesh China in the
widest possible range of international institutions¨ and should draw China into a
responsible role of cooperative global leadership, notably as regards the rules-based
system of economic governance.
The EU should lead by example, keeping our market open in order to allow our
consumers and firms as well as other countries - including China - to benefit from the
opportunities associated with economic openness. The EU should therefore strive to
maintain open access to our internal market and avoid misuse of the safeguards that trade
rules put at our disposal to respond to protectionist demands.
However, it will be increasingly difficult to defend openness in the years to come, as the
EU grapples with the problems of adapting to challenges and as China (more wrongly
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than rightly) is viewed as the main culprit of painful trade-induced change. The policy
response outlined above (objective 4) would enable Europe to cope more effectively with
the kind of challenge presented by China. However, convincing citizens of the benefits of
maintaining openness while facilitating change requires a well thought-through
communication strategy.
This challenge will be stronger if China does not allow meaningful and effective access
to its market. Therefore, the economic openness should be embedded in reciprocity.
Chinese economic nationalism is bad for the world, but it is also bad for China in the
long run. China has benefited spectacularly from its reinsertion into the world economy.
This economic might is increasingly lending it political influence. However, with power
comes responsibility for the principles, norms, rules and procedures underpinning the
world economy. Clearly, China`s interests are heavily dependent on open markets, as its
past growth performance has made clear. China has a clear interest in an open trade and
investment environment. Indeed, in many cases China has shown a willingness to
shoulder this responsibility. But challenges remain. A number of areas can be
highlighted:
In(erna(/ana/ (rade (WTO). In general, China is keeping up with its schedule of
complying with WTO commitments; in some areas it is even ahead. While most
tariffs and quotas have been eliminated as foreseen, effective foreign penetration in
Chinese markets often remains limited. As one set of barriers are dismantled (i.e.
tariffs), others become more glaring (i.e. non-tariff barriers). Policy will have to focus
more on factors hampering de facto market access. It is essential for the EU to have
full access to China`s rapidly growing market. Especially in strategic¨ goods and
service sectors, like cars and petrochemicals, banking and telecom, effective market
access remains an issue. A number of areas stand out:
Intellectual property rights. Despite significant progress, there is still no proper
enforcement of intellectual property rights; significant counterfeiting remains,
leading to major losses for EU firms. China needs to make IPR protection more
consistent, notably as regards enforcement (inter-agency coordination needs
improving). At the same time, EU companies should be encouraged to use
complementary strategic protection mechanisms.
National treatment. Still preferential treatment for domestic companies in some
areas, notably in public procurement, subsidies and easier access to funding by
SOCBs for local firms, especially SOEs, investment restrictions in a number of
sectors, where the EU has a strong advantages such as the automotive sector and
the petrochemical sectors (50%). In other sectors, real investment opportunities
have been restructured by high capital and liquidity requirements (banking) and
licensing procedures (telecom services).
Standards. While adopting certain international standards, China relies largely on
domestic ones. Participation in standard-setting bodies is often not transparent and
not open to foreign participants.
Moreover, within the Doha Round, China could become more active in pushing
for further liberalisation beyond current commitments. Eventually, it would be
natural for China tp indicate a willingness to take on further liberalisation
commitments.
G/aba/ /mba/ances. These are currently at unprecedented levels, and there are
significant risks of a disorderly adjustment. China, like Europe, has a role to play.
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Delivering on commitments is not going to be easy, as illustrated by Europe`s
difficulties in delivering meaningful structural reform. Nevertheless, China needs to
gradually reduce excess savings and revalue the Yuan.
However, addressing the problem of excess savings is a long-term endeavour that
requires careful execution, and includes improving the financial system so that
savings can be better channelled into the real economy and improve social welfare
systems to reduce current incentives for precautionary saving.
Being able to do that without risking economic disorder means speeding up the
restructuring of the financial system and putting in place a more comprehensive
social welfare system. There is a compelling domestic case for China to carry out
these reforms, as this will lay a solid foundation for future high levels of growth.
However, it is all a matter of ensuring an orderly transition. So far, just as the US has
so far failed to address its lack of savings, the moves on the exchange rate side are
clearly insufficient to make a meaningful contribution to dealing with the imbalances.
A more meaningful move is in Europe`s interest, as otherwise the dollar is likely to
depreciate more against the euro.
16.6. Promote 'harmonious` international relations
Engaging China. Apart from enmeshing China in the various institutions which
underpin the world economy, it is also important to anchor China in the wider
international system. China is at a strategic crossroads¨. It has the potential for both
good and bad and will in any case exercise considerable influence. Most probably, as
the Chinese say, harmony with other nations despite differences¨ is an achievable
goal but the question is how many differences can be accommodated without
disturbing the harmony¨ of the international system. In this respect, China needs to
recognise that lack of transparency (e.g. on China`s military build-up) and actions
contradictory to official statements (e.g. on relations with some countries, notably in
Africa) lead to unsettling questions on China`s real intentions. Europe`s interest is to
push China towards the more positive course while avoiding two traps: being viewed
as an interventionist, even imperialist¨ force, and surrendering its founding
principles. Overall, the EU is well placed to engage with China. While the EU's
position not homogeneous, the EU and China nevertheless broadly share a fairly
benign view of multipolarity and multilateralism.
Regionalism. Asia is a diverse and unstable region that is currently undergoing
fundamental changes. A number of countries in the region are busy building domestic
institutions, and nationalism is high. The region is the focal point of China`s
economic and political rise. This has generated tough competition for regional
leadership, with the outcome being uncertain. With China being only part of an Asian
manufacturing value chain, with intensive intra-FDI and trade flows between Japan,
Korea, Taiwan, China and other Asian countries, the EU needs to develop an overall
Asia Strategy. Europe`s interest is in promoting a stable regional order and avoiding
any suspicion of a hidden bilateral agenda or preference. The EU`s unique experience
- Member States willing to share sovereignty in a number of areas - can be put to
good use in the emerging regionalism in the East Asian region. While it is far from
clear which direction East Asian integration is going (divergence of views, historical
sensitivities, unequal power balance, etc), the EU should broadly support East Asian
cooperation and integration (within Asean etc).
United States. The United States is an important regional player and certainly the
single most important country in terms of China`s national interests. For the EU, the
relationship with the United States is considered to be Europe`s most comprehensive
166
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and strategically most important partnership.¨ When developing a China/East Asian
policy, it is essential that the EU understands US views, shaped as they are by the
US`s long-standing involvement in the region and extensive bilateral security
guarantees developed after the Second World War (e.g. with Japan, Taiwan, South
Korea, etc). This security dimension profoundly shapes the US views. While the EU-
US link may form the bedrock of the current security system (e.g. NATO),
views/interests vis-à-vis China/East Asia may well diverge. Nevertheless, Europe
shares a fundamental strategic interest with the United States, i.e. to integrate China
peacefully into the existing multilateral system. The EU should not let China take
advantage of possible divergences between European and American policies, in
particular regarding China. In view of this broad commonality, there is a need to
carefully manage EU-US relations by discovering and dealing with potential
differences well in advance.
The way forward. The assessments on China`s future and its implications for the
international community diverge considerably, but there is agreement on the
uncertainty of any future developments. The EU should build on China`s desire for a
stable environment within which to pursue and sustain its economic growth. This a
period when the EU should be:
Encouraging China towards a smooth transition;
Encouraging China to play a more responsible and constructive role in world
affairs;
Approaching China while keeping in mind the rest of the region - and
keeping in mind Europe`s transatlantic relationship as well;
Enhancing the EU's sensitivity to security concerns.
To engage more effectively with China, the EU needs to establish a more visible
political presence. While frequent high-level visits are useful, their effectiveness
would be improved if they EU could speak with one voice. Naturally, the EU`s
problems in this respect go beyond China. To build up a common strategic outlook
and vision between Member States - e.g. within the CSFP - is a long-term
endeavour. It is a worthwhile one though, as divergences clearly sow confusion and
lessen the EU`s influence in China and the East Asian region at large.
167
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Hypotheses¨, China Centre for Economic Research, Working Paper No. E-2004-004.
Guo, Hongjung and R. Veugelers (2005), MNEs, Internationalisation of R&D and the
Impact on local firms: evidence from China`s High Tech industries, Katholieke
Universiteit Leuven.
Hors, Irène and Zhang Gang (2005), Intellectual Property Rights: Governance
Challenges and Perspectives¨, in OECD (2005a).
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Ianchovichina E, W. Martin (2004) : Impact of China`s Accession to the World Trade
organisation¨, The World Bank Economic Review, vol 18, n°1
International Monetary Fund (2004). China`s Growth and Integration into the World
Economy: Prospects and Challenges¨, Occasional paper, No 232, IMF, Washington
DC.
International Monetary Fund (2005). International Financial Statistics 2005. IMF,
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Li, H and E. Yi (2005). China`s Ascent: Can the Middle Kingdom Meet Its Dreams?¨,
Global Economics Paper, No. 133, Goldman Sachs.
Lehman Brothers (2005), Update of Newton & Subbaraman (2002), China: Gigantic
Possibilities, Present Realities¨. Presentation for the GEPA Meeting, Brussels.
McKinsey (2005). How to fix China`s banking system¨, The McKinsey Quarterly, 2005,
No. 1.
Merton, R.C, Bodie, Z, Sirri, E.R, Tufano, P., Crane, D.B., Froot, K.A., Mason, S.P. and
A.F. Perold (1995). The Global Financial System. a Functional Perspective, Harvard
Business School Press, Boston, Massachusetts.
Newton, A. and R. Subbaraman (2002). China: Gigantic Possibilities, Present
Realities¨, January 2002, Lehman Brothers, London.
Quan Qi and N. Huyghebaert (2006), Share Issuing Privatization in China: Determinants
of Public Share Allocation, Katholieke Universiteit Leuven.
OECD (2000), Reforming China's Enterprises. China in the Global Economy, OECD,
Paris.
OECD (2004). Income Disparities in China. An OECD Perspective, OECD, Paris.
OECD (2005). China¨, OECD Economic Survey, Vol. 2005/13, September, OECD,
Paris.
Reuterswärd, A. (2005), Labour protection in China: Challenges Facing Labour Offices
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Taube, M. (2002), Economic Relations between the PRC and the States of Europe,
China Quarterly, 169, 78-107.
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Unctad (2005), World Investment Report¨ , Unctad, Geneva.
Van den Bulcke, D., Zhang H. Esteves, (2003). European Union, Direct Investment in
China: Characteristics, Challenges and Perspectives, London/New York.
Wei, S-J and Y. Wu (2001). Globalization and Inequality: Evidence from Within
China¨, NBER Working Paper, No. 8611, NBER, Washington DC.
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mobility restrictions¨, NBER Working Paper, No. 10683, NBER, Cambridge.
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http://rru.worldbank.org/DoingBusiness/Main/DoingBusiness2004.aspx
World Bank (2005). World Development Indicators 2005, World Bank, Washington DC.
171
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LIST OF TABLES, GRAPHS AND BOXES
TABLE 1-1: ADMINISTRATIVE DIVISION 5
TABLE 2-1: CHINA`S ECONOMY COMPARED 15
TABLE 2-2: SOURCES OF OUTPUT GROWTH 19
TABLE 2-3: PRIVATE VERSUS PUBLIC SECTOR IN THE CHINESE ECONOMY: % OF VALUE
ADDED BY FIRM OWNERSHIP 22
TABLE 2-4: CHINA`S MANUFACTURING STRUCTURE: SHARE OF VALUE ADDED BY
PRIVATE SECTOR IN MAJOR INDUSTRIES (2003) 22
TABLE 2-5: TRENDS IN CHINA`S SHARE IN WORLD FDI FLOWS 25
TABLE 2-6: SHARE OF FOREIGN ENTERPRISES IN CHINA`S INDUSTRIAL PRODUCTION
GROSS INDUSTRIAL OUTPUT VALUE BY SECTOR 2003 28
TABLE 2-7: SOME S&T INPUT INDICATORS FOR CHINA 31
TABLE 2-8: HUMAN CAPITAL FOR S&T INPUT INDICATORS FOR CHINA 33
TABLE 2-9: PUBLICATIONS AND CITATIONS BY COUNTRY 36
TABLE 2-10: INTERNATIONAL PATENT APPLICATIONS (NUMBER AND SHARE) 36
TABLE 3-1 SHARE IN WORLD MERCHANDISE TRADE BY REGION, 2004 40
TABLE 3-2: CHINA`S REVEALED COMPARATIVE ADVANTAGES IN GLOBAL TRADE, 1995,
1998, 2001 45
TABLE 3-3: TRADE PATTERN AND COMPARATIVE ADVANTAGE BY STAGE OF PRODUCTION
47
TABLE 3-4: CHINA`S OUTWARD-BOUND FDI FLOWS AND FDI STOCK, MIO. US$ 49
TABLE 3-5: CHINA`S TRADE IN ENERGY 51
TABLE 3-6: CHINA`S TRADE IN RAW MATERIALS 51
TABLE 5-1: MACRO-ECONOMIC FUNDAMENTALS IN CHINA 76
TABLE 6-1: PROFITABILITY OF CHINESE AND INTERNATIONAL BANKS (END 2003) 81
TABLE 6-2: FOREIGN INVESTMENT IN CHINA`S BANKS 84
TABLE 7-1: THE IMPORTANCE OF FINANCING CONSTRAINTS FOR CHINESE ENTERPRISES
AND THE CONSEQUENT IMPORTANCE OF RETAINED EARNINGS AS A SOURCE OF
FINANCE 94
TABLE 8-1 SOCIAL SECURITY CONTRIBUTION RATES 104
TABLE 10-1: GDP AND EMPLOYMENT 117
TABLE 13-1: SELF-IDENTIFICATION MEASURE 127
TABLE 14-1: EU-15 TRADE WITH CHINA BY BROAD PRODUCT GROUPS 142
TABLE 14-2: REVEALED COMPARATIVE ADVANTAGE: CHINA VERSUS EU15 146
TABLE 14-3: REVEALED COMPARATIVE ADVANTAGE: NEW MEMBER STATES 147
TABLE 14-4: FDI INFLOWS INTO CHINA, 1995-2002 147
TABLE 14-5: EU-25 FDI OUTFLOWS 1995-2004 148
TABLE 14-6: EUROPEAN FDI FLOWS TO CHINA, 1997-2002, BY COUNTRY 148
List of Figures
FIGURE 1-1: CHINA`S PROVINCES........................................................................................................... 4
FIGURE 1-2: CHINA`S STATE ORGANS.................................................................................................... 7
FIGURE 2-1: FDI INTO CHINA BY COUNTRY OF ORIGIN................................................................. 26
FIGURE 2-2: RATIO OF R&D EXPENDITURE TO VALUE-ADDED BY OWNERSHIP..................... 30
FIGURE 3-1: WORLD EXPORT MARKET SHARES FOR DIFFERENT COUNTRIES/COUNTRY
GROUPINGS (MANUFACTURING) ................................................................................................ 41
FIGURE 3-2: CHINA`S WORLD MARKET SHARE OF IMPORTS BY PARTNER .............................. 42
FIGURE 3-3: CHINA`S TOP 10 TRADING PARTNERS 2005 ................................................................. 43
FIGURE 3-4: TRADE BALANCE OF CHINA VIS-À-VIS TRADING PARTNERS (2005, BILL USD) 44
FIGURE 3-5: WORLD EXPORT MARKET SHARES FOR TELECOMMUNICATION AND
COMPUTERS...................................................................................................................................... 45
FIGURE 3-6: CHINA`S OVERALL TRADE IN INTERMEDIATE GOODS BY MAIN TRADING
PARTNERS.......................................................................................................................................... 48
FIGURE 3-7: CHINA`S OVERALL TRADE IN CAPITAL GOODS BY MAIN TRADING PARTNERS
.............................................................................................................................................................. 48
FIGURE 6-1: DOMESTIC CREDIT PROVIDED BY BANKING SECTOR (% OF GDP, 2004)............. 79
FIGURE 6-2: FOREIGN BANKS` SHARE OF THE BANKING MARKET (2003) ................................. 83
FIGURE 6-3: EQUITY MARKETS IN EMERGING MARKETS (SHARE GDP) .................................... 85
172
01_2006_4142_txt_EN.indd 172 12-07-2007 10:44:05
FIGURE 6-4: MARKET CAPITALISATION AND MARKET CAPITALISATION OF TRADABLE
SHARES TO GDP ............................................................................................................................... 86
FIGURE 8-1: STRUCTURE OF SELECTED GOVERNMENT REVENUES (2003) ............................... 99
FIGURE 8-3: TOP EXPENDITURE ITEMS.............................................................................................. 102
FIGURE 10-1: EMPLOYMENT AND GDP.............................................................................................. 115
FIGURE 10-2 REGISTERED URBAN UNEMPLOYMENT.................................................................... 116
FIGURE 10-3: MIGRATION...................................................................................................................... 119
FIGURE 11-2: INEQUALITY IN CHINA COMPARED TO OTHER DEVELOPING COUNTRIES ... 121
FIGURE 11-3 INEQUALITY WITHIN CHINA........................................................................................ 122
FIGURE 14-1: SHIFTS IN THE GEOGRAPHICAL FOCUS OF EU-15 EXPORTS
(MANUFACTURING) ...................................................................................................................... 140
FIGURE 14-2: EU-15 TRADE WITH CHINA .......................................................................................... 141
FIGURE 14-3: EXTRA-EU-15 TRADE BALANCES............................................................................... 141
FIGURE 14-4: SHARE OF MANUFACTURING EXPORTS TO THE EU-15 BY TYPE OF SECTOR144
FIGURE 14-5: EUROPEAN FDI FLOWS TO CHINA, 2002 .................................................................. 149
FIGURE 15-1: CURRENT ARCHITECTURE OF EU-CHINA RELATIONS......................................... 152
List of boxes
BOX 1-1: A SNAPSHOT OF CHINA`S RECENT HISTORY...................................................................... 3
BOX 1-2: MEMBERS OF THE POLITBURO`S STANDING COMMITTEE............................................. 8
BOX 1-3: THE EIGHT DEMOCRATIC* PARTIES..................................................................................... 9
BOX 1-4: CHINA`S ELEVENTH FIVE-YEAR PROGRAMME (2006-2010) .......................................... 10
BOX 1-5: CHINA`S DEFENCE WHITE PAPER - COMMAND OF THE SEA, COMMAND OF THE
AIR AND STRATEGIC COUNTER-STRIKES................................................................................. 13
BOX 2-1: LISTS OF MAJOR REFORMS FOR ECONOMIC GROWTH.................................................. 16
BOX 2-2: ECONOMIC IMPACT OF CHINA`S WTO ACCESSION ....................................................... 17
BOX 2-3: CHINA`S ECONOMIC STRUCTURE........................................................................................ 20
BOX 2-4: THE ECONOMIC PRESENCE OF HONG KONG AND TAIWAN ON THE MAINLAND.. 27
BOX 2-5: MAJOR CHINESE GOVERNMENT R&D FUNDING PROGRAMMES ................................ 32
BOX 2-6: FOREIGN PROVIDERS OF HIGHER EDUCATION ............................................................... 34
BOX 2-7: CHINA`S PARTICIPATION IN ERASMUS MUNDUS EXCHANGE OF STUDENTS AND
SCHOLARS......................................................................................................................................... 35
BOX 2-8: THE GLOBALISATION EXPERIENCES OF CHINA AND INDIA COMPARED................. 38
BOX 4-1: CHINA RUSSIA RELATIONS.................................................................................................... 60
BOX 4-2: THE TAIWAN ISSUE : THREE DIFFERENT VIEWS ON THE STATUS OF TAIWAN...... 63
BOX 4-3: CHINA AND THE DEVELOPING WORLD.............................................................................. 72
BOX 5-1: WHAT IS THE FAIR¨ VALUE OF THE RENMINBI?............................................................ 77
BOX 7-1: CHINA`S INDUSTRIAL POLICY.............................................................................................. 93
BOX 7-2: CHINA`S COMPETITION LAW................................................................................................ 9
BOX 10-1: HUKOU: A SYSTEM OF REGISTRATION IN PROGRESS................................................ 118
BOX 14-1: CHINA, THE EU AND IT ....................................................................................................... 144
BOX 14-2: CHINA, TEXTILES, THE EU AND THE WTO .................................................................... 144
7
173
01_2006_4142_txt_EN.indd 173 12-07-2007 10:44:05
LIST OF ACRONYMS
Asean: Association of South-East Asian Nations
APEC: Asia-Pacific Economic Cooperation
CASS: the Chinese Academy of Social Sciences
CCB: City Commercial Banks
CCP: China`s Communist Party
CEIBS: China-Europe International Business School
CEPA: Closer Economic Partnership Agreement (between China and Hong Kong)
CFSP: Common Foreign and Security Policy
CICIR: China Institute of Contemporary International Relations
CNY: Chinese Yuan
GSP: Community System of Generalized Tariff Preferences
CPPCCS: People`s Political Consultative Conferences.
CSRC: China`s Securities Regulatory Commission.
EU: European Union
FDI: Foreign direct Investment
FEER: Fundamental equilibrium exchange rate
FRS: Fondation pour la Recherche Stratégique (FRS - Paris)
FTA: Free Trade Agreements
GATS: Generalised Agreement on Trade in Services
GDP: Gross Domestic Product
GERD: Gross Expenditures on R&D
ICCPR: International Covenant on Civil and Political Rights
ICT: Information & Communication Technology
ILO: International Labour Organisation
IMF: International Monetary Fund
IPR: intellectual property rights
JSB: Joint Stock Banks
KMT: Nationalist Party or Kuomintang
LLC: limited liability companies
LP Legal Person (LP)
MNE: Multi-national Enterprise
Mofcom: Ministry of Finance and Commerce
MOST : Ministry of Science and Technology
NBS: National Bureau of Statistics
NELG: National Energy Leading Group
NGO: Non-Governmental Organisation
NMS: New Member states (EU)
NNSF: National Natural Science Foundation
NPC: National People`s Congress.
NPL: Non-performing loans
OECD: Organisation for Economic Co-operation and Development
PLA: People`s Liberation Army.
PPP: Purchasing power parity
PRC: People`s Republic of China
PRI: Public Research Institutes
R&D: Research and Development
RCA: Revealed comparative advantage
RCB: Rural Commercial Banks
RMB: Renminbi
S&E: Scientists & Engineers,
S&T: Science and Technology
SAIC : State Administration of Industry and Commerce
SASAC: the State Assets Supervision and Administration Commission
SCI Science Citation Index
SCO: Shanghai Cooperation Organization
SEAsia: South-East Asia
SEPA: State Environment Protection administration
SIPO: in Chinese patents
SME: Small and Medium-sized enterprises
SOCB: State Owned Commercial Banks
174
01_2006_4142_txt_EN.indd 174 12-07-2007 10:44:06
SOE: State Owned Enterprises
TAC: Treaty of Amity and Cooperation in Southeast Asia
TVE: Township and Village Enterprises
UN: United Nations
Unctad: United Nations Conference on Trade and Development
US: United-States
USPTO United States Patents and Trademark Office
VAT: Value-Added Tax
WFOE: Wholly foreign-owned enterprises
WHO: World Health Organization
WIPO World Intellectual Property Organisation
WTO: World trade organisation
175
01_2006_4142_txt_EN.indd 175 12-07-2007 10:44:06
01_2006_4142_txt_EN.indd 176 12-07-2007 10:44:06
European Commission
China, the EU and the world: growing in harmony?
Luxembourg: Offce for Offcial Publications of the European Communities
2007 - xxii, 175 pp. - 17.6 x 25 cm
ISBN 92-79-03556-8
01_2006_4142_txt_EN.indd 177 12-07-2007 10:44:06
01_2006_4142_txt_EN.indd 178 12-07-2007 10:44:06

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European Commission China.indd 177 12-07-2007 10:44:06 . the EU and the world: growing in harmony? Nwzgodqwti<"QhÞeg"hqt"QhÞekcn"Rwdnkecvkqpu"qh"vjg"Gwtqrgcp"Eqoowpkvkgu 4229"Ð"zzkk."397"rr0"Ð"3908"z"47"eo ISBN 92-79-03556-8 01_2006_4142_txt_EN.

01_2006_4142_txt_EN.indd 178 12-07-2007 10:44:06 .

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